KEY POINTS:
Reserve Bank Governor Alan Bollard's plea to all New Zealand's economic players - Government, households and firms - to make decisions in the best interests of the country's growth and stability is a wake-up call everyone should head.
We're talking the "R" word here. A recession could happen if the galloping global credit crunch, combined with some less-than-adroit policy decisions, persuades the international finance community that New Zealand is no longer a good risk.
This is probably why Bollard has also signalled that interest rate hikes have probably come to an end and the bank believes it is on top of inflation.
While Bollard has been careful not to over-play his message that New Zealand economic policy has to be alert to emerging shocks, the mere fact that he has pointed to what happened when the golden weather came to an abrupt end in the early 1970s should be warning enough.
A major economic boom stopped as the first oil shock hit here and Britain slapped restrictions on our farm exports as it entered the European Common Market.
"As a consequence New Zealand entered a prolonged period of high inflation and low growth, which eventually precipitated a painful but necessary period of major economic restructuring," said Bollard.
Most new entrants to the New Zealand housing market will be too young to remember the 1970s fallout. Property prices crashed as people struggled to pay high mortgage interest rates (then about the 12 per cent for first mortgages).
Many people lost equity in their homes and were forced into mortgagee sales or had to convert to interest-only loans and even capitalised interest payments.
It took a long time for house prices, and the fortunes of those New Zealanders who had their equity wiped out, to recover.
Unlike now, the 1970s correction followed a period when banks and financial lending institutions were much more conservative in how they applied their loans criteria.
The fact that an average-income couple can now obtain 100 per cent finance for a $397,000 mortgage, as highlighted in the New Zealand Herald, is a worry.
If the bubble bursts, what will the couple's financial institution do if the valuation of their house slides, or the cost of money escalates at mortgage rollover time? This is an important question because if there is a major housing market fallout it is unclear what the mainly Australian-owned banks will do.
Bollard suggested the standard central bank response when a bubble bursts was to stand ready to clean up the mess by easing monetary policy and stimulating demand. But in his address to Canterbury manufacturers on Friday he did not indicate if that was what he would do.
The verbal semaphore was telling enough. Bollard pointed to substantial dissaving by households on the back of lower interest rates that had enabled them to service a higher level of debt; financial innovation that had eased credit constraints; and generally buoyant employment conditions.
Despite this, net household wealth had increased because of the effect of house price gains. He questioned how sustainable this was.
The Reserve Bank's single focus is to use monetary policy to keep inflation in the 1-3 per cent band.
The problem is that it has very crude tools when it comes to managing debt-fuelled consumer spending, which is a major contributor to inflation.
While house prices are not included directly in the consumer price index (it measures construction costs of new dwellings), increasing house prices in recent years have had an indirect effect on inflation.
New Zealanders have basically been borrowing off the equity in their houses to fuel consumption on things such as overseas trips, plasma TVs or new kitchens - via revolving credit mortgages and other instruments.
It would appear that it is only a matter of time before there is a long-overdue correction to the housing market bubble as householders' budgets are stretched as they try to service mortgages with snowballing interest rates.
This is exactly what has happened in the US and parts of Europe. There is no reason New Zealand, where house price affordability is a major issue, should be immune.
Bollard's standard line in the past has been to suggest there is a considerable period of pain to come before inflation is controlled.
But on Friday he told reporters that New Zealand's record-high benchmark interest rate should be enough to deal with inflation.
"Our picture at the minute is that rates are roughly where they should be and we don't see any reason to change that," he said in a story reported by Bloomberg. "We can see ourselves on top" of inflation.
Other issues that could cause economic shocks are surging oil prices, the commodity price boom, and efforts to mitigate climate change. These risks are much more difficult to assess than is the fallout as the synchronised global housing market boom unwinds or the potential for a personal consumption shock as people try to cut back debt.
The commodity price boom, in which dairy farmers' incomes have swelled on the back of China's demand for agricultural products, the effects of climate change policies on energy prices and oil price surges, are also much harder to predict.
It's quite possible that the Reserve Bank is wrong about how these things will affect inflation, as too many variables are at play.
Bollard's sober message should not be read in isolation. The outlook his Australian counterpart gave on January 17 is also worth reading.
Reserve Bank of Australia Governor Glenn Stevens assured a London business conference that the Australian banking institutions were well capitalised. "While their direct exposure to the US sub-prime market has been limited, we have seen additional demand for liquidity put upward pressure on term funding rates for financial institutions, though to a smaller extent than in Europe or the US, and the pressures are easing somewhat," he said.
Stevens indicated credit was still available to sound borrowers. It now cost a bit more, but that was in the context of a fully employed economy struggling to meet demand.
"The key banking institutions are strongly capitalised, have adequate liquidity and relatively little exposure to the problems in the US housing market."
Stevens, acknowledged widely as a good operator, did not labour the potential for the international credit crunch to severely affect Australia.
His rather monodimensional message was geared to ensuring economic confidence in Australia.
The fact that Bollard has now stopped warning international investors about the risks New Zealand presents is also geared to the need to retain confidence.
