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Wednesday, 25 February 2009

How low can you go?

Infometrics article first published in the Dom Post 22/5/09 about interest rates and how they affect the economy.

My mate Pete is building a house. He is a talented builder and property developer, but the recent change in the market has left him needing to complete and sell his current project this year. He works every hour that the inclement Wellington weather allows, and practically sleeps with his drill clasped in his calloused hand. Pete dances a little jig every time Alan Bollard drops interest rates. He has a floating mortgage, and every little fall gives him precious extra time or money to finish up the house and get it sold or rented.

After years of being synonymous with the Grim Reaper, Dr Bollard is enjoying a reincarnation as Santa Claus. Every time Dr Bollard is on tele now, mortgage rates fall. But Pete isn’t really sure why Dr Bollard has gone from zero to hero. Why is he so busy lowering rates now, when they were so high before?

Alan Bollard runs the Reserve Bank, which is where banks settle up their transactions each day. Like all central banks, the Reserve Bank acts as a 'banker of bankers', lending banks cash when they are short and overseeing the financial industry. As a result of the problems caused by inflation in the 1970’s, nowadays Reserve Banks tend to be independent from Government and focused on controlling inflation. The method our Reserve Bank uses to control inflation has varied since the 1980’s. Currently the Reserve Bank uses the Official Cash Rate (OCR) – this is the short term interest rate they offer to banks for overnight loans and deposits.

Changes in the OCR should (in theory) flow through to bank floating deposit and loan rates. Banks won't offer on-call deposit rates higher than the OCR because they can borrow cash from the Reserve Bank at around that rate. Theoretically, banks could also offer floating rate loans at the OCR rate plus a margin to cover their costs and risks.

Lower short term interest rates have a knock-on effect right through the economy, which is where Pete starts getting interested. When borrowing costs fall, it allows Pete to spend more on materials and labour. It also becomes easier for people and businesses to borrow more to spend and invest, although Pete, like many of us, is wary of borrowing more at the moment. Lower interest rates mean fewer overseas investors are interested in putting their money here, and our exchange rate falls. Our dollar has fallen over the last year, which is great if you are exporting, but not so hot if you have a penchant for imported German power tools like Pete.

This is all a good kick-start for the New Zealand economy in tough times. When times are good - too good – Dr Bollard puts interest rates up with the opposite effect. These interest rate changes flow through the economy, stoking or cooling the pace of growth with the intention of keeping prices reasonably stable.

This formula has served us pretty well for the past two decades, providing reasonably stable, low inflation growth. But around the world monetary policy isn’t working as well as it used to do. Since 1987 every time that economic strife has struck, central banks have lowered interest rates, allowing consumers to take on more debt, enabling economies to spend their way out of the crisis. This has created what we economists call a moral hazard – borrowers and the financial industry got saved by low interest rates every time they got in trouble, so they kept taking bigger risks. Now, very rightly, borrowers are unwilling to take on more debt, and lenders are wary of bad loans. There are only so many houses Pete can buy and do up at once, and he doesn’t want any more debt right now. Debt levels are now so high and interest rates so low that central banks can’t save the day. This is the problem the US and the UK face now, which is why they have turned to printing money.

But the problem isn’t simply the level of debt, it’s what we’ve used the money for. We used cheap debt to bid up the prices of our own houses, which has proven to be a poor investment for NZ Inc. Partly this outcome is a result of the tax benefits that housing enjoys. These incentives have encouraged productive, energetic people like Pete to focus their skills on building houses rather than doing other stuff, like creating something for export. It just so happens he’s a pretty good web designer too.

Falling interest rates work for Pete right now. Hopefully the low OCR will actually get passed on to floating mortgage rates, and buy him some more time to finish his house. In the mean time let’s hope a capital gains tax (at least on second homes) is being seriously considered in the Beehive. This would dampen our housing obsession and focus the ingenuity of people like Pete on more sustainable ways of growing our economy.

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