Property speculation has led to edge of a precipice

The economist, John Maynard Keynes, pointed out "the fallacy of composition" in the 1930s.

This riddle states that what holds true in the parts may not hold true for the whole.

Keynes was referring to what occurred during the 1930s Depression as people tried to save more and reduce debt.

The effect was to reduce total spending in the economy leading to more unemployment making matters even worse.

What may appear sensible for an individual may not be sensible for a nation.

The fallacy applies to speculative investment in housing.

Individuals can get rich by buying and selling houses but a country cannot.

This is the problem that we are now slowly starting to recognise.

Over the past decade we have borrowed huge sums from overseas and used this to finance an investment boom in houses.

House prices have rocketed but so have private debt levels.

We have used overseas borrowing to bid up our own house prices.

The end result is that we now live in expensive houses earning modest incomes and wonder why our economy is going nowhere and we struggle to pay the bills.

Economic growth occurs when there is an increase in the output of saleable goods and services for an economy.

If I borrow $500,000 from a bank that has itself borrowed this money from overseas, then New Zealand's foreign debt has increased by this amount.

If I use this money to buy an existing house, then I have a house worth $500,000 and a debt of $500,000.

The seller now has $500,000 cash.

There has been no increase in output nor has there been an increase in our future ability to produce.

There has been no wealth created for New Zealand in this transaction.

The recent report by the Savings Taskforce states in blunt terms that New Zealand stands at the edge of a precipice largely as a result of the process described above.

We have incurred massive debts without increasing our capacity to repay them.

Sadly, we have done it to ourselves.

In the past 15 years, our total overseas debt has mushroomed from $75 billion to $253 billion.

This is largely private rather than government debt.

Much of this debt has been lent out by banks to allow us to bid up our own house prices.

It has not been used to create new productive capacity for our economy.

During that same period our housing stock has only increased by about 24%.

Most of the borrowing has been dissipated in housing inflation rather than the construction of new houses.

The likely factor that will tip us over this precipice is a sudden fall in the value of the New Zealand dollar.

Our dollar has long been overvalued against most other currencies that we trade with.

The inflow of borrowing from abroad has helped maintain the value of our currency.

Any major economic crisis, either here or abroad, could precipitate a rapid fall in our currency.

It would quickly become apparent how much we have been living beyond our means.

The prices of all tradeable items, both imports and exports, would rise rapidly.

We compete with overseas consumers even for the products that are produced locally.

There would be a dramatic increase in the cost of living.

The real impact of our decade-long savings and investment folly has been disguised by an overvalued currency.

Policy options are limited.

There is a need to create a savings culture, but more important is the need to encourage productive investments that grow the economy.

A capital gains tax could dissuade speculative property investment but any sudden policy lurch in this area runs the risk of creating a housing crash.

Tackling the constraints on housing construction such as resource consents, permits, zoning and inspections and material costs should be a priority.

The cost of new housing puts a constraint on housing speculation and inflation.

The proliferation of rules and regulations on housing construction and land use needs to be carefully examined.

Such constraints benefit existing home owners to the detriment of young first home buyers.

There is also an urgent need for financial literacy training in our schools.

This requires an investment in teacher education and resourcing.

We need to create an investment culture where students can learn to appreciate that astute financial management is a key to a good life.

Houses are for people to live in while they produce saleable goods and services.

This is what increases our standard of living.

The current unaffordability of housing is a major roadblock to national prosperity.

Savings should be used to invest in machinery, technology, factories, skills and new businesses to increase our output and standard of living.

Treating houses as a speculative investment may enrich individuals but not a nation.

Policy changes to encourage savings and productive investment need to dovetail with initiatives to make housing more affordable.

People cannot save if they are paying off huge mortgages.

• Peter Lyons teaches economics at Saint Peter's College, in Epsom, and has written several economics texts.