KEY POINTS:
Psychologists call it denial. This is when a patient refuses to accept a trauma has occurred or is occurring.
The situation confronting our economy reflects such a scenario. Many seem to believe the severity of what is occurring overseas is passing us by. More likely the delay in impact here is due to our unwillingness to accept the reality of the situation.
For much of the past decade, our economy has been driven by a debt-fuelled housing boom. This created a feel-good wealth effect that enticed people to borrow and spend more based on capital gains in their house values.
Banks and other lenders went on a lending splurge, justified by the rising value of the housing collateral that they were lending against. It created a circular effect - increased lending driving house prices, allowing further lending.
This process is now moving into reverse. Quotable Value has just announced that average house prices fell by 7 per cent last year. This seems relatively benign compared with the dramatic slumps in residential property prices in Britain and the US.
It is more likely a reflection of the unwillingness of many New Zealanders to accept prices below their expectations. They would rather withdraw their property from the market and wait for prices to pick up.
It could be a long wait. The most telling figure in our housing market is the slump in sales volumes of around 50 per cent. There is a negative wealth effect taking hold.
As house prices decline, people feel less wealthy and cut back on spending. This fall in demand creates unemployment which adds to the decline in house prices.
To compound this situation, the banks are reluctant to lend as the value of their collateral slips away. This is evidenced by the failure of the banks to pass on the full cuts made by the Reserve Bank to the Official Cash Rate.
They cannot find enough sound lending opportunities in a situation of declining house prices and rising unemployment.
The banks have been criticised for failing to pass on the full interest rate cuts made by the Reserve Bank. They are finally being prudent in their lending by necessity. They are fearful of rising bad debts which could erode their capital. Government guarantees of depositors' funds do not provide any safeguards for bank shareholders against rising default rates.
There has been lots of talk about the nature of our banking system and the soundness of their balance sheets. The reality is that they have been central to the housing bubble that has engulfed New Zealand through their imprudent lending habits.
As a result, the value of their collateral is now under pressure and they have suddenly rediscovered the merits of prudent lending.
Mr Key's recent announcement that his tax cuts and the ability of the Reserve Bank to further cut interest rates should mitigate some of damage provides little assurance. Tax cuts are unlikely to provide a great deal of stimulus to the economy for several reasons.
If the cuts are used for spending, much of it will be on imports, therefore helping other economies rather than our own. More likely the loss of business and consumers' confidence will mean the cuts will be used for savings or reducing debt levels as people fear for their job security.
The Reserve Bank's ability to stimulate the economy through interest rate cuts is also limited and questionable. The idea is that interest rate cuts will allow the banks to increase their lending, but as mentioned there is a lack of suitable borrowers and sound collateral. Given that much of bank lending is for housing, it is difficult to see how further debt-fuelled house buying will help us out of the current situation. It may make matters worse as more Kiwis become indebted to buy an asset that is declining in price.
First home buyers are still suffering despite falling prices. Banks have raised the equity requirements to protect themselves from falling collateral values. The return to 80 per cent lending means that a first home buyer in Auckland would require equity of at least $70,000 for a modest purchase. This major impediment to new entrants further amplifies the decline in prices.
At the other end of the market, elderly people wishing to sell to move into a retirement village or home are likely to delay the sale to wait out the slump. This is apparent in the falling share prices of listed retirement operators such as Ryman and Metlifecare.
Our economy is very vulnerable given our inflated house prices and extreme levels of private debt. We need to be honest in appraising the situation to develop strategies to mitigate the worst effects. We must be careful not to blindly follow economic doctrines that may worsen the situation.
Peter Lyons teaches economics at St Peter's College in Epsom and has written several economics texts.
