Belgian dentists will lose their enthusiasm for funding our mortgages.

NEW ZEALAND has been going through a housing price bubble since 2002. It may be about to end, ironically, because the Reserve Bank chose not to raise interest rates in the face of market expectations that it would.

John Calverley, in The Investor's Guide to Economic Fundamentals says of the Japanese real estate mania of the late 1980s: "The drivers for this bubble were, as usual, optimism and liquidity." Let's apply this principle to New Zealand in the 2000s.

First, optimism. For optimism, we can read "expectations." By 2002 the economy was in full recovery, driven by among other things, a low exchange rate, low interest rates by the standards of the previous decades and an influx of migrants and students. With rising rents and the prospect of significant capital gains, expected returns to residential property increased substantially.

A bubble, born out of such optimism, continued because it was supported by liquidity. NZ banks, in particular, started to fall over themselves in the scramble to supply mortgage finance.

As interest rates increased from 2004, the liquidity factor in housing strengthened rather than weakened.

While optimism waned in much of published commentary, rational expectations were that future land prices would rise because of the continued growth in the availability of mortgage credit.

At no point since 2004 would it have been rational to expect a downturn in housing prices.

To understand this, we need to appreciate some subtleties about the workings of debt markets in open economies, as well as the economic theory of rational expectations (especially the "efficient markets" hypothesis which is the application of that theory to financial markets) which was the major development in macroeconomics in the late twentieth century.

In any economy, rising interest rates lead to reduced investment spending on capital goods.

Under such interest rate conditions, lending on residential property becomes relatively favoured over more risky business lending. This means a general fall in the rate of lending growth may, nevertheless, be accompanied by a rise in liquidity in the residential property sector.

This is particularly likely if a bubble is already under way.

If capital gains in residential property of 10% per annum are being realised, a rise in interest rates to 8%-9% will do little to deter borrowers in this sector. As long as borrowers continue to borrow and banks continue to increase their market shares in the favoured housing sector, the housing market will continue to realise capital gains and fuel expectations of further gains.

The process is limited in a closed self-sufficient economy by the decline of non-housing investment, which soon enough generates a contraction in the business cycle. When incomes fall and unemployment rises, pessimism outweighs the continued growth of expenditure on housing. A correction in the housing market follows. Interest rates fall and banks increasingly lend to other sectors.

In a fully open economy, the situation becomes more complex.

Not only do we get overseas-based investors buying residential property in New Zealand, we also get increased flows of foreign savings entering our banking system, chasing high and rising interest rates. Further, by pushing up the exchange rate, lending to businesses that make exportable products becomes even less attractive, and mortgage lending becomes relatively more attractive.

As long as low-priced, externally- sourced finance continues to be available (and profitable for the banks) the normal limits to the growth of liquidity in housing do not operate.

The determinant of liquidity in New Zealand's housing market is thus the interest rate margin between New Zealand and the next country, which for us is Australia.

With an interest rate margin over Australia of, say, two percentage points, there are "unexploited profit opportunities." Australian Banks profit by lending more to New Zealand banks, increasing mortgage liquidity in New Zealand while decreasing it in Australia.

Further, savings from "Japanese housewives" and "Belgian dentists" flow into New Zealand. A closer interest rate margin between New Zealand and Australia would see the bulk of that money going into Australia instead of New Zealand.

Normally unexploited profit opportunities in financial markets are closed as they are taken advantage of. However, the Reserve Bank of New Zealand, by raising the official cash rate in 2004 and 2005, has kept those opportunities open. But by not raising interest rates in October while Australia raised its rate to 6.25% last week, the margin between the two countries' interest rates is finally reducing. This can be expected to gradually shut off the overflow of mortgage liquidity that has driven New Zealand's housing bubble.

My analysis suggests rising interest rates in New Zealand have been a cause of the inflation in asset prices that Reserve Bank governor Alan Bollard has been so concerned about.

The solution, for us, is to bring New Zealand interest rates in line with Australia's. Further reductions in interest rates would lead to increases in lending to businesses in the tradeable sector, and to a reduction in the share of bank finance that goes into housing.

* Keith Rankin is a lecturer in economics at Unitec New Zealand.