Welcome to life after the housing boom

The key to understanding what has been, is and will be going on in the economy is to appreciate the dominating role of the recent humungous housing boom.

Until sometime last year, the economy went through a period of strong and often above-trend growth, the chief cause of which was a boom in the new and established housing markets.

Investment in new housing and renovations was running at up to 2 percentage points of gross domestic product above its long-term average.

But consumer spending – which accounts for about 60 per cent of GDP – was also growing well above trend, hitting average annual growth of 5.6 per cent in 2003-04.

It seems clear the housing boom was the primary cause of the outsized growth in consumption. For one thing, when you build a new house – or just extend or renovate an old one – you’re inclined to go out and fill it with new furniture and appliances.

For another, the nationwide doubling in established house prices over the six years to March 2004 prompted a “wealth effect” undoubtedly bigger than we’ve ever experienced before.

As the value of their homes soared, people felt a lot wealthier and so let out their belts. They allowed their consumption spending to increase a lot faster than the growth in their disposable incomes, so that the household saving ratio fell from 5.6 per cent in 1996-97 to minus 3.2 per cent in 2003-04.

Whereas the traditional behaviour of home-buyers had been to pay off their mortgages as soon as they could, thereby continuously increasing their equity in their homes, many households withdrew equity by increasing their mortgage and using the funds to support their lifestyle.

We’ve had plenty of housing booms in our time, but nothing on this scale. It had three peculiar causes. First, the delayed effect of the financial deregulation of the mid-1980s in spreading innovation and intense competition from commercial lending to home mortgage lending.

As part of this, we saw the advent of the home-equity loan – the device that facilitated the wealth effect. It allowed people to withdraw some of the equity in their home and spend it on consumption.

The second cause was the belated return to low inflation and the consequent halving of nominal mortgage interest rates, which roughly doubled the borrowing power of home owners.

This, in turn, unleashed a long-suppressed desire of many people to improve the quality of their housing. Unfortunately, when so many people decided to “trade up” at pretty much the same time, we got a boom of unprecedented size that managed to double the price of a largely unchanged stock of houses.

The third cause was the Howard Government’s decision to leave the negative-gearing loophole open while reducing the value of superannuation concessions to high-income earners and halving the tax on capital gains.

The result was an orgy of investment in rental properties – investment far out of line with the demand from renters – which has left many better-off households over-exposed to a decline in house and unit prices or a rise in interest rates.

The investment property orgy probably made a significant contribution to the doubling in house and apartment prices.

Everyone knows that, from 2001, the housing-led boom in domestic demand was accompanied by a contraction in external demand as export volumes stopped growing while import volumes grew in double figures.

What many people don’t realise, I suspect, is that the housing boom effectively crowded out external demand (“net exports”). You can see this from two perspectives. The first is that, on the one hand, the housing boom added to consumption and so reduced saving while, on the other, it added to investment (in the housing stock). So, by reducing national saving and increasing national investment, the housing boom caused a widening of the current account deficit.

(As part of this, the fact that some people consumed the increase in the value of their housing meant that, to supply the credit necessary to finance the huge growth in lending, the banks had to borrow heavily from abroad, thereby adding to the capital account surplus and net foreign debt.)

The second way to think of it is that, thanks to the economic growth emanating from the housing boom, the unemployment rate fell steadily to a 28-year low of 5 per cent.

The Reserve Bank would not have wanted to see the economy growing any faster than it did. In its management of demand along the path it took, the Reserve kept the official interest rate higher than otherwise, which probably kept the exchange rate higher than otherwise, thereby crowding out net exports.

That covers the housing boom’s part in where we’ve been. Where we are now is that the economy has been slowing. It’s slowing not because the Reserve jammed on the brakes but because the boom is petering out.

Home building activity is contracting slowly. House prices have stopped rising and are now “flat to down”, which has ended the positive wealth effect. Consumer spending is slowing as households, not feeling as flush, end their spending binge and focus on repairing their balance sheets – getting on top of their debts and reducing their dis-saving.

With employment still growing so strongly, it’s hard to be sure just when the economy began slowing or how slow it is now. But for convenience, let’s accept the Government’s forecast of year-average growth of 2 per cent in the financial year just ending and 3 per cent in the coming financial year.

What happens now? Well, assuming the air keeps escaping from the housing bubble at such an orderly rate – with home building declining only modestly and housing prices steady rather than falling sharply – we could be in for several years of restrained growth.

If so, that would be one solution to the question that must be at the forefront of the economic managers’ minds: how binding is the supply constraint? To put it in terms the Reserve would never use, is an unemployment rate of 5 per cent above or below the “non-accelerating-inflation” rate of unemployment?

If we’re below the NAIRU, it’s only a matter of time before clear signs of excessive wage growth emerge. The Reserve would head off the threat to inflation by raising interest rates, thus slowing growth further and getting unemployment drifting up until it was safely above the NAIRU again.

But if we’re still above the NAIRU and thus no signs of inflation pressure emerge, continued weak growth would cause unemployment to drift up. This would be dis-inflationary and would prompt the Reserve to cut interest rates.

With any luck, a fall in interest rates – possibly combined with falling commodity prices as the world resources boom subsides – could cause our dollar to fall and improve the international competitiveness of our export and import-competing industries.

Which brings us to the last part of the puzzle. With domestic demand likely to be subdued for some time, when is external demand going to recover and take over some of the running?

With the miners bringing new production capacity on line and overcoming infrastructure bottlenecks, there’s some prospect of faster growth in export volumes in the coming year. And with weaker domestic demand, there’s some prospect of slightly slower growth in the volume of imports.

But it’s hard to see much of an improvement in net exports – and thus a return to faster growth – until (for whatever reason, domestic or external) the dollar falls and makes us more competitive.

Ross Gittins is the Herald’s Economics Editor.