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John Maynard Keynes called it "animal spirits". It refers to the collective emotions that can drive markets. Endemic optimism or pessimism are the key culprits.
The Sydney housing market is experiencing the latter at present after years of riding the former. Median house prices have slumped by over 6% in the past year. The pace of decline appears to be accelerating. Auction clearance rates have fallen dramatically and there is a huge backlog of unsold properties. Vendors appear to be willing to take a hit in order to sell.
It is worth exploring the anatomy of this slump because it highlights a little appreciated aspect of the economic landscape that is applicable to New Zealand.
Several years ago, I was approached by a TV documentary maker. His specialty was rock movie docos. But he had developed an acute interest in modern finance since the Global Financial Crisis.
I spent a pleasant morning being interviewed and filmed by him and his cameraman. As I departed I suggested to him he faced a huge challenge. The dark magic of finance seems to hold little appeal to the wider public due to its inherent complexity. It is likely this is why the Occupy Wall Street movement eventually fizzled out. People knew something in finance stank but were unsure exactly what. Sadly, the documentary has never screened, possibly due to my less than telegenic appearance.
The key point I wanted to make in the interview was that banks can get it horribly wrong in their lending practices and this has enormous implications for a society. Far more than any other industry in a modern economy. The dirty little secret of modern economics is that private banks create most of the money in the economy. Most modern money is simply debits and credits in bank computer systems. During a housing boom, banks are collectively willing to lend more because the value of collateral is going up. People want to borrow more to climb on the rising housing ladder. So the debits and credits in the banking system magically multiply. House prices rise, people are eager to borrow more, banks are eager to lend more, so house prices continue to rise. A self-fulfilling cycle emerges. But then the music stops.
At this stage, the cycle shifts into reverse. This is now playing out in Sydney and other housing hot spots in Australia.
As house prices start falling and houses become harder to sell, the banks take fright. They become less willing to lend. They are fearful of bad debts and the falling value of their collateral. Because there is less bank lending there are fewer buyers in the market. Because there are fewer buyers the prices of houses continue to fall. Vendors who are urgent to sell are forced to take a hit. As house prices continue to fall, banks are more reluctant to lend. A vicious downward spiral has emerged.
Bankers have got a very bad rap in recent decades. To be fair, they are also trapped in a strange market dynamic. During a boom in house prices they must compete for market share in their lending. Any banking CEO who sat on the sideline during an asset boom would soon lose his or her job. Bank credit is generally the accelerant to any asset price boom such as housing or shares. This was why the banking sector in most countries was so tightly regulated following the 1930s Depression. There was a general awareness of the damage that could be created if the bankers got their lending wrong.
The key dynamic of the banking system that makes it unique from other industries is the ability to create credit. The deregulation of the finance sector in the past 40 years has unleashed this genie. A housing boom allows the banks to create more credit, which further fuels the boom, allowing more credit creation. Unfortunately, this process can prove very nasty in reverse. This is now playing out in Sydney and other parts of Australia. Let’s hope it’s not contagious.
- Peter Lyons teaches economics at Saint Peter’s College in Epsom and has written several economics texts.