Economist Brian Easton examines how speculative bubbles have occurred in the New Zealand housing market

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

Speculative bubbles are common. The Global Financial Crisis of 2008 was an example, as was the New Zealand finance companies’ crash about the same time. The 1987 share market crash was another example, as was the 1929 Wall St Crash. There are at least two major bubbles going on at the moment – one in the crypto-currency market and one in the Chinese Financial System.

Hyman Minsky provided one of the best ways to analyse such bubbles: ‘the financial system swings between robustness and fragility and these swings are an integral part of the process that generates the business cycle’. He thought that such financial instability – and the booms and busts which accompanies it – was inevitable in a so-called ‘free’ market economy, unless government steps in to control through regulation, central bank action and other tools.

 His key mechanism that pushes an economy towards a crisis is the accumulation of debt by the non-government sector. There are three types of borrowers that contribute to this debt:

            The hedge borrower can make debt payments which cover interest and principal from current cash flows from investments.

            For the speculative borrower, the cash flow from investments can cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal.

            The Ponzi borrower – named after Charles Ponzi who ran the famous ‘Ponzi scheme’ in 1920 – believes that the appreciation of the value of the asset will be sufficient to refinance the debt because insufficient cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat.

These three types of borrowers each dominate in one of Minsky’s three phases of the financial bubble. During the Hedge Phase, banks and borrowers are cautious. Loans are minimal so that borrowers can afford to repay both the initial principal and the interest. It is the ‘Goldilocks’ phase of debt accumulation – ‘not too hot not too cold’.

The Speculative Phase emerges as confidence in the financial system recovers during the Hedge Phase. Borrowers no longer invest on the basis that they can pay both principal and interest. Instead loans are issued for which borrowers can afford to pay only the interest. As the loan principal comes up for payment, they rely on being able to refinance (‘roll over’) their debt, borrowing the principal again. The decline towards financial instability begins.

As confidence continues to grow, investors move into the Ponzi Phase in which they neither pay the interest on the loans nor repay the principal. They rely on the capital appreciation from what they have invested to finance their investing.

The asset-price appreciation that the Ponzi investors rely upon cannot go on forever, especially as it needs to accelerate. Eventually, Stein’s law – if something cannot go on forever, it will stop – takes its toll. Some Ponzi investors withdraw, and there are not enough new investors introducing new cash to fund the withdrawing Ponzi investors.

And so the bubble pops at the ‘Minsky Moment’ after which everyone tries to get out of their investment commitments, turning them back into cash. Ponzi borrowers are forced to, because they have no cash; speculative borrowers can no longer refinance the principal even if they are able to cover interest payments. The prices of assets fall, with innocent lenders suffering as well as guilty borrowers.

Not everyone suffers. There are those who have taken their margin on each transaction, such as investment promoters, sharebrokers, investment advisers, real estate agents, All have an incentive to encourage speculative investment, which biases the public view towards risky investments. Other beneficiaries are those who invest and cash up before the Minsky Moment. There is also a more sophisticated group of investors who ‘short’ the market, that is, contract to sell the assets at high prices after the Minsky Moment. (Michael Lewis’s The Big Short described shorting during the Global Financial Crisis.)

New Zealand’s housing market fits Minsky’s model reasonably well.

Nowadays, the housing market is largely funded by borrowing from banks. From the 1980s, after the financial liberalisation which, among other things, ended the trading banks having separate savings banks, the housing market was first in Minsky’s Hedge Phase. The banks’ lending was cautious, with their funds for lending largely coming from deposits and loan repayments. Mortgages were advanced on the basis that borrowers could afford to pay the interest and repay the initial principal over a long period reflecting their working lifetime.

Minsky’s Speculative Phase began in the early 2000s where, following 9/11, the George W Bush administration flooded international markets with dollar liquidity. Our trading banks turned to those international markets for additional funds, which were used to increase the supply of mortgages.

It became easier to purchase a house because there were more funds. But the supply of housing did not increase much. So the price of housing rose. Borrowers still serviced their mortgages but they were now getting a good return from the capital gain from the faster appreciation of housing prices. By 2007, housing prices were about 50% above the trend of the 1990s relative to consumer prices.

There was almost a domestic financial crash. In 2008, trading banks were borrowing about $30 billion a month in offshore markets, partly to increase their advances but mainly to roll over existing borrowing which was short term – three months – much shorter than the mortgage advances they were making to house owners. During the GFC, financial markets almost seized up, when international lenders in crisis themselves became unwilling to roll over their past advances – to everyone, not just to New Zealand banks. Fortunately, international cooperation between the central banks of the world prevented the catastrophe.

New Zealand managed to get through the GFC reasonably lightly, compared to some other countries; its house prices fell a bit.

From 2014 the housing prices began moving up again. It was partly over-confidence but nominal interest rates were low, which meant that house purchasers could service larger mortgages. Again there was not much increase in the housing stock, so the price of housing went up dramatically.

The government tried to restrain the house price rises including by imposing a capital gains tax on houses which were quickly resold and loan-to-value requirements on lenders. Additionally, it ring-fenced rental income so that landlord operating losses could no longer be set against other taxable income (notably wage income) although any capital gains they made remained untaxed. Such measures stabilised prices from 2017 to 2020 but at about 70% above the 1990s trend.

But the quantitative easing of the early 2020s (as a part of the Covid package) flooded cash into the banks, who lent it out for housing. It is common to say that such cash stimulates inflation. It did, but not this time in consumer prices. Housing and collectables prices inflated.

By 2021 house prices were about double what they would have been had the mild increases of the 1990s continued. The inevitable happened, especially when mortgage interest rates began rising following rising international interest rates. The Minsky Moment arrived. By the end of 2021 house prices were falling everywhere. How far they will fall one cannot tell, especially as the stock of housing is ramping up.

*Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.