Brian Fallow: Optimism based on return to bad habits

There is a danger the recovery is based on the kind of behaviour that got us into trouble in the first place. Photo / Brett Phibbs

What are we to make of the sunburst of optimism apparent lately?

Consumer confidence has jumped to a four-year high, business confidence to a 10-year high.

Harder data tell a similar story. House prices have been rising since February. World prices for export commodities have been rising since March. The NZX-50 is up nearly a third from its low in March. And the dollar has been back above US70c for a couple of months now.

So are happy days here again?

Or is this optimism built on foundations of meringue - a deeply mistaken belief that the status quo before the crisis was normality to which we can now happily return?

There are some reasons for caution.

Headline measures of sentiment reflect the results of a basically binary question: Do you think things are going to get better or worse? After so steep a fall and so almighty a fright it is unsurprising we reach a point where most think things can only get better from here.

But are they putting their money where their mouths are?

Up to a point. Retail sales in the three months to August were up 0.7 per cent on the three months before that, in dollar terms.

That is despite the fact that incomes are flatlining and likely to continue to, as wages are the last cab off the rank in any recovery.

Instead people are saving less.

Reserve Bank data show growth in households' bank deposits, including PIEs, on a declining trend all year, with year-on-year growth now the weakest since May 2004.

That is not a healthy trend when savings rates are deeply negative, with households spending $1.08 for every $1 of disposable income.

Businesses may be more upbeat about their prospects but their investment and hiring intentions are weak and expected to remain so in light of the amount of spare capacity in the economy after five quarters of contraction.

House prices, as measured by REINZ's house price index, are just 4.4 per cent lower than their all-time high in November 2007, or 8 per cent in real terms, and rising.

That is hardly the big correction the Reserve Bank and other forecasters were calling for. It leaves intact the large deterioration in the basic metrics of housing affordability which occurred during the boom.

The ratio of household debt to disposable income rose from 60 per cent in 1990 to 100 per cent in 2000 and over 160 per cent by its 2007 peak. It has only come back to 157 per cent.

Even with interest rates around cyclical lows, debt servicing costs of 12.2 per cent are well above the average of 9.6 per cent since the early 1990s.

This does not look like the platform for another sustained rise in house prices such as we saw between 2002 and 2007.

ANZ National Bank economists in their quarterly forecasts released this week argue that what we experienced in those boom years was not normal and we are unlikely to return to that environment.

"During that time credit growth ran at two to three times the rate of nominal GDP growth, house prices almost doubled in real terms and there was a general expectation that asset prices could continue to grow at double-digit rates. Cash flow fundamentals were supplanted by expectations of strong capital gains. The byproducts were nasty imbalances, including excessive leverage and risk-taking, a high current account deficit, significant affordability issues ... Policymakers would be irresponsible to let such behaviour and imbalances return."

Quite.

But are we seeing the beginnings of a return to the same behaviour, what you might call a recidivist recovery?

The revival of the housing market could just be a case of first in, first out (of the recession). Rising house prices could be a case of pent-up demand meeting reluctant vendors.

People may be accurately predicting that the net effect of higher net migration inflows and a construction slump will create at least a temporary shortage.

The real question is whether people, babyboomers especially, have shed the idea that the best way to provide for their retirement is not to save money but to borrow money, for a leveraged play in the housing market.

Slipping back into that way of thinking could be a costly mistake.

For one thing, the surge in population growth from net migration could prove short-lived.

It is driven by fewer people leaving for Australia. But the lucky country has avoided recession and is doing well enough for its central bank to be raising interest rates already.

On the outlook for local interest rates, retail rates are already higher than the official cash rate by an unusually wide margin. There is a stark difference between what the Reserve Bank has been saying - that it does not expect to start to raise the OCR until "the latter part" of next year - and market pricing, which implies the best part of 2 percentage points increase in the OCR by then.

Two of the major banks raised their two-year fixed mortgage rates this week.

Rents have not been rising fast - just 1.7 per cent in the year to June. Even when house prices were rising at double-digit rates rents increased much more slowly.

With unemployment still rising and incomes going sideways, landlords' pricing power and prospective rental yields may not be all that strong.

Finally there has to be some chance that the tax rules will change.

Is it realistic to expect a cash-strapped Government to overlook the fact that some $200 billion of investment in rental properties on a net basis yields it no revenue and in fact between $150 million and $200 million of losses to offset other taxable income?

Meanwhile on the international front there is a similar picture of structural problems still unaddressed.

In particular there is what looks like an increasingly unstable hybrid system where half the world economy is in a US dollar bloc (China, the petro economies of the Gulf and of course the United States itself) while the rest have floating exchange rates.

How long will China and the US stay together in a loveless marriage over a currency peg, hanging in there for the sake of the bond market? It is Beijing's call and when you are that big no one can make you do what you don't want to.

And how low would the US dollar go, if Chinese and Gulf authorities did not buy huge quantities to recycle their trade surpluses?

Then there is the question of how sturdy the nascent global recovery will be when, inevitably, the plaster cast of ultra-easy monetary policy is removed and the medicated high of fiscal stimulus wears off.

In an ideal world we would now be in the throes of an export-led recovery, while households rebuilt their savings and reduced their debt.

Instead the opposite is happening.