Keith Rankin
Housing In New Zealand: A Giffen Good?
In the 19th century, Robert Giffen, an English statistician, noted that Irish peasants demanded more potatoes when the
price of potatoes went up. This contradicted the law of demand, one of the most iron of the iron laws of economics.
Maybe this is what gave the Irish a reputation for being, well, "Irish".
The explanation is quite rational. For the peasants in the west of Ireland, expenditure on their staple food, potatoes,
represented a very large proportion of their incomes. If the price of potatoes, which were much cheaper than any other
form of food, went up, then the proportion of their income available to purchase other foods would shrink markedly. No
longer being able to afford other foods, they would spend that remaining income on the cheapest food, namely potatoes.
Giffen goods may exist at the other end of the socio-economic spectrum. Conspicuous consumption is all about rich people
displaying their wealth. If some outrageously expensive item that is a status symbol becomes even more expensive, and is
widely known to have become more expensive, then it becomes even more attractive as a status symbol. This probably is
true of the works of certain artists; maybe Colin McCahon is one artist whose works have become more valuable because
they have become more valuable.
To most economists, conspicuous consumption is irrational. But most status symbols attract a capital gain. It is
rational to want something very expensive more than when it was less expensive if you believe that there will be someone
else waiting to buy it off you at an even higher price than the exorbitant price you paid. Tulip bulbs were once
grotesquely overpriced Giffen Goods, in Holland in the 17th century.
Maybe everything that is bought and sold for capital gain is a Giffen good, or a potential Giffen good; a good that
people demand more of when its price rises. Because, when prices of tradeable assets rise, we expect those prices to
keep rising
Real estate is an obvious candidate. (Others are, of course, shares, bonds, foreign exchange; indeed just about any
financial asset.)
Residential housing is of particular interest because of the way it is financed by profit-maximising banks. So before I
consider housing itself as a Giffen good, I'll argue that mortgages are Giffen goods.
The price of a mortgage is the rate of interest on mortgages. For our purposes, we can treat the Reserve Bank's Official
Cash Rate (OCR) as a measure of the price of mortgage finance.
Conventional wisdom says that, if interest rates go up the quantity of mortgage finance demanded goes down.
Let's assume that there is a fixed amount of finance available for all purposes: business finance, residential
mortgages, and consumer credit. When the interest rate rises, the quantity of business finance demanded drops off the
most. Further, business lending becomes more risky, so banks will seek to supply relatively less credit to businesses
and relatively more to households. Banks will advertise mortgages - which, unlike credit cards, are secured - more
vigorously when they are cautious about business lending.
Banks' need for customers does not diminish. In a recession, banks supply more credit to their customers with the best
security.
When people think that house prices will rise, they demand more housing. As economists would say, the extra demand
arising from expected price increases may well more than offset the fall in quantity demanded arising from the price
increases that have happened.
Banks are more willing than ever to lend on housing, whatever the risk of default, if they are confident that any
mortgagee sale will fully recoup their faulty investments.
The growth of mortgage credit in response to rising interest rates reinforces any existing expectation that house prices
will rise. It is a mutually self-fulfilling prophecy; the fulfilled expectations of prospective house buyers reinforce
the fulfilled expectations of the banks.
It is really worse than that. The amount of credit in total is not fixed (as I earlier assumed). Rising interest rates
may lead to more domestic savings. On the other hand, reduced business investment leads to unemployment which leads to
less savings. But, on the first hand, rising interest rates attract foreign savings. We would say that there is an
increase in the quantity of foreign savings supplied to the New Zealand capital market. Much of this capital inflow is
initiated by banks in New Zealand seeking to expand their mortgage lending.
This foreign capital inflow raises the $NZ exchange rate, which, in turn, further diminishes the desire of the banks to
lend to businesses. That further fall in business lending further raises the supply of mortgage finance, which in turn
further fuels real estate inflation (especially in Auckland and Wellington), which in turn further fuels expectations of
further house price rises, which causes the demand for real estate to increase further.
What I have described is exactly what happened in New Zealand from 1994 to 1997. Yet the Reserve Bank still thinks that
raising interest rates will dampen rather than fuel the residential housing market.
I believe that something similar to 1994 is already under way in New Zealand, and that the Reserve Bank's raising of the
OCR to 5% in March will lead to less business lending than would otherwise have happened, and therefore will lead to
more mortgage lending than would have happened had the OCR stayed at 4.75%.
Having said that, I do not believe that there will be as great a housing bubble in Auckland as there was 6 to 8 years
ago. Interest rates are much lower now than they were before the last cycle commenced. Likewise, the exchange rate is
lower than it was in early 1994. So the fall off in business lending as a share of all bank lending is unlikely to be
anything like as great as it was in the mid-1990s.
Nevertheless, a new real estate bubble will happen, and will be fuelled rather than dampened by rises in interest rates
that are intended to stifle such inflation. This time the rise in property prices is likely to be much more evenly
spread throughout the country.
The growth in the demand for housing will only fall once the perception ceases that capital gains can be made from
housing. Capital gains taxes, or taxes on tax-exempt income deriving from owner-occupied housing would certainly dampen
those perceptions.
Otherwise, the real estate bubble will likely burst when the Reserve Bank moves into an easing phase of interest rates.
That's when business lending will start to become more attractive, and the mortgage credit that fuels the demand for
residential property will stop growing.
House prices hardly moved when interest rates followed their downwards cycle from 1998 to 2001. It will be the same for
the next cycle, and the cycle after that; unless that is there is a radical rethink of the intellectual foundations of
monetary policy.
Housing is a Giffen good. Demand for housing increases when people and banks expect house prices to rise, and that
expectation is fuelled by actual price rises. Demand for housing decreases when falling interest rates encourage banks
to lend more on businesses and less on home finance.
© 2002 Keith Rankin