As a homeowner, buy-to-rent investor, or property speculator, it is hard to see New Zealand's booming property market as anything but a positive development when looking through the prism of common sense.

The latest round of data from QV show housing prices rose 10 per cent last year, not a bad return by any measure, but made even juicier once you factor in the tax free nature of the capital gains.

And, if like many people, you're counting the future value of your home in your retirement planning, then it is quite reassuring that your savings are looking healthier and healthier.

Even if you are not anywhere near ready for retirement, you can rest assured that your first step on the property ladder will pay off in the long-term, which is why people as young as 22 are applying for mortgages.

After all, a growing population and a shortfall in new housing supply suggest the trend is only going to continue.

It's just a pity that this view, although common, doesn't actually make a lot of sense when viewed through a different prism: economics. What at first glance appears to be a no-lose situation can have perverse outcomes further down the track that are not immediately obvious to property owners.

It is all part of what economists call the "wealth effect". This is a process whereby a link between perceived level of wealth and spending was discovered.

In practical terms this suggests that if the value of your house rose from $400,000 in 2009 to $650,000 (a compound annual growth rate of just over 10 per cent), you are more inclined to consume more goods and services to keep pace with your new perceived wealth.

The problem is that while your paper wealth may have increased, your salary earnings haven't - in fact they probably fell when you consider that council rates are based on the value of your property. And since income, as a general rule, is relatively finite and inflexible, as spending increases, so savings rates tend to drop off.

The wealth effect can also be applied to how much debt households take on. In this scenario, a borrower is prevented from taking debt over a certain level based the value of their collateral.

However, in a booming property market, the value of the borrower's home would increase, allowing them to borrow more, presumably to the point where their spending levels match their perceived level of wealth.

The most obvious example of this in real life was in the US in what would later emerge as the subprime mortgage crisis.

People saw the value of their properties surge ahead of income growth, and tapped this increased "wealth" in the form of second mortgages or higher borrowing from other sources.
 
The wealth effect also works in reverse. If house prices fall dramatically, people will curtail their spending just as quickly. That can have a dramatic impact on the overall economy, leading to a drop in gross domestic product (GDP), but the real risk lies in people not being able trim this spending because of debt servicing costs.

You can see why the Reserve Bank is worried, and why Governor Graeme Wheeler pulled the trigger on tight loan-to-value-restrictions (LVR) last year.

However, the LVR policy should be viewed for what it is - a temporary band aid on a gaping wound. The LVRs may have slowed activity in the market, but they have not relieved the pressure on the housing market.

LVRs have not built a single new house - in fact it may have the opposite effect if the Registered Master Builders Federation is to be believed.

That is why The New Zealand Initiative has been advocating for an increase in the supply of land available for development. While high material costs, dis-economies of scale in the home construction sector, and restrictive building regulations have all played a part in adding to the cost of a new home, the price of land is the biggest expense in a new build.

The problem is also not one that can be fixed with a silver bullet. A multi-tiered approach needs to be adopted, one that address local government funding, regulatory and planning restrictions, and infrastructure costs to name a few.

This complexity is why we advocate for the housing market to be managed under a market-led approach.

Highly centralised and restrictive housing markets in places like the UK have be unable to deliver affordable housing in the long-term, while market-led regions like Germany, Switzerland and parts of the US have produced stable house prices in real terms for decades.

Clearly, if we are serious about insulating our economy from some major (but easily spotted) fiscal risks, housing is a good place to start.

Source: Land supply key to the economy