Matt Nolan

Be careful saying that housing is “taking away” from businesses

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There is an interesting narrative running around at the moment.  Liam Dann articulates it in the Herald:

But wait, there is more; this property investment tradition is deeply damaging to the long-term growth of the New Zealand economy.

As well as accelerating property prices it is taking investment capital away from the productive, job creating sector.

What this country needs is more jobs and higher wages, as most people would want to learn how to setup SMSF and make regular payments. That’s means more wealth-creating companies and more growth for the companies we have. Our companies need local capital.

We need a thriving stockmarket that small businesses aren’t afraid to list on. We need great pools of savings to invest in smart Kiwi companies.

Sounds fair enough right – since we are all (well not me, but other people) buying up houses off each other, we are borrowing dollars for this.  These dollars could instead go to innovate firms!  Another way of viewing it is that our demand for buying other peoples houses is  pushing up the interest rate, and that this is increasing the cost of lending to innovate firms.

Ok ok, let’s just stop right there for a second.  House prices are appreciating due to the large shortage of property (in Auckland this is especially the case), and recent improvement in credit availability.  Now the improvement in credit availability is actually reducing interest rates for “innovative firms” – but let’s put that to the side as well.

Let’s instead pretend that there is just a fixed pool of capital.  It isn’t true, but it is what this argument is based on.  And let us also ignore the fact there is a housing shortage and a terribly low build rate – instead we will assume that no houses are being built, and that there is no population growth, and no aging, and nothing that will change the composition or quality of houses required.

In this case, when people “borrow to buy houses off each other” (the primary concern of bubble proponents) we aren’t removing capital from the stock available for businesses.  Remember, the person who borrows to buy a house then gives someone else a bunch of wealth – which they can in turn invest or save (which will then go back to become credit available for our “innovative businesses”).  In the case where there is no actual INVESTMENT in housing, we aren’t (on the face of it) restricting business investment by buying property!!!

All the factors I ruled out above are reason we SHOULD invest – they are drivers that indicate we need to invest, or they were actual investment.  A bubble is supposed to “crowd out” investment to other areas by leading to TOO MUCH investment – we should be experiencing TOO MUCH building … but this isn’t what is happening. [Note:  Even if you do not believe there is a shortage of property in of itself, build rates remain low.  As a result, part of any concern about a housing bubble needs to be premised with “and I expect a sharp increase in spending on residential investment”]

We could argue that it is due to risk – the more mortgages that are written up, and the larger gross debt is, the more risk banks are taking on and as a result the less they are willing to lend to other business types!  This is true – but to think about this we have to ask about how banks view relative risk (Note:  A bubble should make mortgages relatively riskier, which in turn should (depending on regulation) make them PREFER our innovative businesses – it is on the willingness to borrow side whether things are out of whack).

We can argue about what is going on with this, and what regulation should be – but arguing that the rising house prices and a low level of building activity is crowding out local investment is fallacious.

Sidenote

This “productive vs non-productive” distinction is investment isn’t economics – it is a value-judgement.  It sounds like economics, it even smells a bit like economics.  But an economist recognises that a house provides a set of “rental services” and that an individual is willing to invest in something that provides a “low rate of return” if they trust it.  We need to ask about relative risk, relative insurance, relative returns for different investment classes (including housing) rather than giving housing a demeaning name and then expecting people to change their behaviour.

Matt Nolan

The OBR is not meant to be a replacement for deposit guarantees

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I’ve noticed an interesting interpretation of the Open Bank Resolution going around New Zealand, and the world, where it is seen as a replacement for the lender of last resort function and deposit guarantees.

This has caused outrage among some – even I’ve received some emails and facebook messages from people on it.  But the OBR and implicit/explicit deposit insurance are actually two incredibly different issues.

The OBR is a scheme that helps to ensure that, when a financial institution fails, it is wound down in an orderly fashion – it is like an addition to standard bankruptcy law specifically for financial institutions.  The OBR takes the fact that, if debt has “gone bad” there are a range of creditors, and the loss needs to be attributed between them.  This is great, it makes what is going on transparent, and helps reduce the interruptions associated with the collapse of a large financial institution!

But it doesn’t say anything about the government’s willingness to allow depositors to lose out from a failure.  Any implicit government guarantee that existed still exists.  In Table 1 of the RBNZ’s recent bulletin article on the OBR this is made relatively clear – the idea of inherent insurance is not applicable to the scheme.

Now I think the logic people are taking onboard is as follows:

  1. When it is clear how a bank will be shut down, it is more likely that the government will do so instead of bailing it out.
  2. Therefore, by setting all this up, it is less likely depositors will be bailed out.

While this is true, I think that it inherently misses the point for extremely large financial institutions – such as the big banks in NZ.  Governments have an incentive to bail out depositors, and there may well be a presumed “social preference” for a risk free place to save that doesn’t lose value which is where this is coming from (given that the value of cash depreciates over time).  If we really want the government to be able to commit to not bailing out deposit, and we want society to be comfortable with it, we need to face these issues – which are separate issues from the appropriate focus of the OBR.

Personally, I think the OBR is great – I just think people’s view of its “purpose” has been stretched out of proportion.

Matt Nolan

Political equilibrium, OBR, and deposit insurance

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There has been some discussion of deposit insurance, the open bank resolution plan, and the types of risks being faced by New Zealand savers.  This is actually a hugely important issue, and as a broad matter of principle I actually find myself agreeing more with Labour and the Greens than National and the Reserve Bank.  My view is that deposit insurance should be announced, it should be explicit, there should be certainty around it, and it should be treated as a form of “compulsory insurance” with the payment of an associated “insurance levy on debt financing” for financial institutions over a certain size.  Of course, even with this the OBR still has a place (it is actually a very separate issue) – and that is why the RBNZ was right in saying this.

In order to see why this is the conclusion I’ve drawn, one that differs from current policy, let’s have a brief look at my thought process through a post.

Political equilibrium, credibility, and expectations

Bailouts are a topic that the government, Treasury, and the RBNZ are justifiably wanting to avoid talking about too much in public.  Why this is justifiable, but the reason why we may need to be more transparent about it, comes from thinking about the expectations of people both within and outside of a bank run.

Governments and central banks are perceived by people in the economy to be the lender of last resort – due to a view on bank runs.  Having a functioning lender of last resort means that, in the worst case scenario, these institutions will act as a lender of last resort.  In this way, the NZ government is expected to bail out large financial institutions (in the NZ case banks) if they fail.

Now on the face of it we might not like this.  We don’t bail out other large companies.  And with an implicit backstop, financial institutions will take on too much risk (and the people funding these institutions will assume there is far less risk) – this is the problem of moral hazard.  In this way, the expectation of a bailout creates a difference between the “full social riskiness” associated with lending and the risk that private individuals and firms face when deciding to lend and borrow between each other, through a bank.

The Treasury, government, and RBNZ acknowledge this moral hazard issue – and so they want to introduce the open bank resolution policy settings as a way of avoiding bank runs (which is why we have deposit insurance in the first place), insuring the bankruptcy is orderly for financial institutions (to make the costs to everyone involved, from negotiating about who gets what, as small as possible), and limiting the number of situations where “bailouts” will really be required.

This is good, this is exactly what they should do.  However, the scheme lacks three things when it comes to thinking about “expectations”:

  1. Clarity about how losses are determined and split in a typical situation that requires bankruptcy – an issue that will be solved soon.
  2. Clarity around how this links to the lender of last resort function of the central bank.
  3. The political incentives to bailout banks.

Let us be honest here.  The government will not let a bank fail.  They will not let depositors lose money.  It is in the government’s interest during a bank failure to have taxpayers pick up the tab.  People know that the government will do this (or at least form expectations based on this) as so will lend to banks in a way where they are seen as riskless!  There is an implicit deposit guarantee scheme for banks at the moment!  This is the key point – even if we aren’t admitting it, there is a deposit guarantee running at present that we aren’t acknowledging.

As a result, it makes sense to turn around and make this explicit.  Note:  If the government thinks it can costlessly credibly commit to not bailing out institutions, and the RBNZ can solve the issue of bank runs without full deposit insurance, then this is good.  But we do not have that right now, not in the slightest, and it should be admitted as policy relevant.

This doesn’t seem particularly fair on the taxpayers

No it doesn’t.  According to most free instant cash advance apps, the tax payer is essentially subsidising loans.  The subsidy is then split between depositors, the banks, and the borrow due to relative elasticities, information, and bargaining positions.  Overall “too much” is invested due to what is socially optimal … this is where we have the “too much debt” business.

If we make the deposit guarantee explicit instead of implicit and we completely remove the loss from default – if anything it will exacerbate the moral hazard issue issue!  So what do we do?

Deposit guarantees are a form of insurance.  Generally, you pay for insurance with an insurance levy.  If we have an explicit guarantee scheme on deposits, then there should be a levy on those deposits.

Yes this will reduce investment, yes this will see lower returns to depositors, but without doing this we have a deposit guarantee scheme that just costs everyone in NZ and in turn makes the entire financial system more unstable.

The kicker with all this is that the insurance scheme will have to be compulsory for all institutions over some type of nominal size.  The type of bank failure we are concerned about, and which will lead to bail outs, stems from an episode where there is systemic risk to the banking sector as a whole.  In that case the incentive to take on the insurance for an individual firm does not match the full social return associated with it.  Furthermore, if the bank decides to take on insurance it may be seen as a signal of weakness (given asymmetric information) making banks unwilling to take on the insurance for signaling reasons.  Finally, the political eqm argument suggests that a government may well bail out the bank irrespective of whether they have taken on the insurance – making a bank unwilling to pay for insurance they can expect to get anyway.

Conclusion

At the moment there are two ways forward when thinking about banking policy in NZ:

  1. Explicit deposit insurance, with an associated deposit levy.
  2. A credible commitment by government that it won’t guarantee deposits combined with RBNZ regulation that can avoid bank runs.

Current policy is trying to push towards the second (which is admirable), but in the current environment I do not believe it is credible given the idea of “political incentives”.  Which is why I find the idea of explicit deposit insurance combined with a deposit levy to be the best way forward.

Note:  Concern about levies is a fair point.  If we are the only country “not subsidising”, what does that mean for us?  I’d note that the big runs here come from trying to introduce this during a crisis – it doesn’t rule out the effectiveness of the policy outside of a crisis.  In a number of ways this would be similar to the FDIC – just with appropriate insurance premiums (which are ex-ante pretty danged hard to determine), and with an appropriate scale to ensure that the government can commit to no more additional bailouts.

Note 2:  Good post by Eric stating why he thinks the government can commit.

RBNZ cannot bind future governments. But setting up the regime well in advance of a bank failure specifying that, no matter what else happens, the equity and (subordinated) bond holders get burned first gives those agents reasonable expectation that they should try to make sure that doesn’t happen. If some future government defects by bailing out depositors, I’d expect it to happen only after burning through the equity and bondholders.

Note 3:  The Economist points out research by the IMF that shows explicit deposit insurance makes the moral hazard problem more acute – this is a pretty easy to understand idea, and we mentioned the concept above (just under our second subtitle).  This is why we both require a levy, and have to accept that it is “inefficient” relative to a situation where the government commits to not bailing out banks AND we have a way to prevent bank runs (where by this I mean optimally reduce the probability of a bank run so the expected cost of it happening is equal to the expected cost of introducing preventative measures).  If we can do that second bit – then do it, and scrap the compulsory insurance.

Matt Nolan

Bubbles, FDI, winners and losers

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I’m so sorry I am still away – currently a bit caught up!  I will be back posting properly and answering comments in a few days.

For now, here is the latest article I’ve popped up on Rates Blog.

In it I discuss what it means for there to be a “bubble” due to foriegn investment, and I mull over long-term foriegn investment.  I am relatively terse in the article, this probably stems from my lack of sleep and the fact I’m busy 😉

I conclude:

Foreign investment and the associated capital flows have been a net positive for New Zealand in the past.

Let’s not forget this as we try to figure out what policy to set in a post-Global Financial Crisis world.

I have no doubt that this article will be unpopular with close to everyone.  That is fine.

Will Taylor

“Living wage a test of small business’ mettle”

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Via Stuff this morning, great quotes from FIRST union leader Robert Reid:

“Why should a worker suffer for being employed by a business that maybe shouldn’t exist,”

As the debate about the living wage continues, we get yet another indication that unions are fine with unemployment – as their clients aren’t the unemployed.

Dom Stephens from Westpac (NZ’s 17th sexiest economist) is quoted further down in the article and rebuts things nicely, so I will just leave it there:

Large increases lifting the minimum wage above where the free market put it – “and I think it [proposed living wage] may be moving toward that” – very clearly affected employment, Stephens said. “It would worsen things for the most vulnerable members of society and improve the lot of those who stayed employed.”

 

Matt Nolan

Keeping it all together on bond sales

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Hey all, I’ve been away – and I still am.  I’ll be back next week.  However, I have to write on this.  Over on Rates Blog, Bernard Hickey stated the following:

The most interesting revelation from today’s Monetary Policy Statement was Graeme Wheeler’s comment that he knew other central banks were buying New Zealand government bonds as part of their Reserve buying programmes.

This is how printed money is lifting our currency to over-valued levels.

Ok, now I don’t know what the RBNZ has been saying – I don’t go to their media lock-up.  But lets think through this a bit.

“Bond buying” will push up the currency if there is some sort of financial flow – such as the government increasing borrowing (and it being funded from overseas) or bond holders in NZ selling bonds to overseas buyers.  From what is indicated, it seems like we’ve had a bit of both.  So the government is borrowing to pay for a bunch of stuff, and this is increasing the current account deficit.  We need a corresponding lift in the capital account surplus to pay for it – hence we have this financial inflow.  People are willing to lend to us incredibly cheaply so this is pretty nice of them.

The two complaints I’m hearing are:

  1. It pushes up the dollar:  Investment+consumption > savings, so yes this pushes up the dollar.  The question is why the interest rate and exchange rates that puts us in our current “balance” seem so high relative to other countries.  Is it because our growth prospects are better?  If so this is good.  Is it because of some structural issues in our economy?  If so this could be bad.  Is it because, as the RBNZ seems to believe, there is a bubble in the dollar/bond markets – if so we have people overpaying New Zealander’s to buy bonds that will decline in price … interesting.
  2. Why don’t we print/pay for it domestically:  This is part of the “QE for NZ” crew view, and it is inappropriate.  Keep the ideas together here, what are we trying to “solve” by getting the central bank to buy government bonds?  Are we trying to loosen monetary conditions … if so cut interest rates, as QE is really a form of this.  Are we trying to reduce foriegn lending … if so we need to reduce domestic borrowing, we are a small open economy and so we pay the world interest rate to borrow as much as we want (in a sense).  If monetary conditions are appropriate, then QE will just be inflationary, and it does nothing about the inherent “savings-investment imbalance” that people are concerned about when they discuss people lending to NZers.