Auction clearance rates fell below 50 per cent in Sydney's outer suburbs Credit:Rob Homer That begs a big question for the city: what should we expect after the boom? The best-case scenario is for house price growth to gradually ease back to a sustainable rate in line with the growth in wages. But even a benign slowdown like that is very unlikely to be pain-free. The inevitable pull-back in house prices is almost certain to have an economic spillover for Sydney. "Housing is a central part of the Australian economy and it has a big impact on the economic cycle," says Oliver. Research by Terry Rawnsley, an expert in regional economics at the consultancy SGS Economics and Planning, has revealed how Sydney's economic performance over the past three decades has been closely tied to the fortunes of the property market.

A surge in home building has been a major contributor to Sydney's economic strength. Credit:Bloomberg "When the economy is going well housing goes well and when housing is going well the economy keeps going," says Rawnsley. "There's a circularity to it." When Rawnsley looked back at Sydney's economic performance since 1993 he found economic growth "punched along" at between 3 and 4 per cent when the housing market is strong. But when house prices are flat, the city's economic growth rate has tended be around 2 per cent or lower. "It's pretty obvious that the city's economic growth has a bit of a valley when property prices are flat," he says. The recent performance of the Sydney economy is in keeping with the patterns Rawnsley has identified. The latest surge in house prices has coincided with robust economic conditions.

The city's economy grew by 4.5 per cent last financial year, the fastest rate since the Sydney hosted the 2000 Olympics and the third best on record. Nearly 40 per cent of all growth in the Australian economy in 2015-16 was generated in Sydney – the largest proportion in almost a quarter of a century. A surge in home building has been a major contributor to Sydney's economic strength. The number of dwelling approvals in NSW has more than doubled during the past five years to a record 75,000. But a slowdown in property prices could weaken the sector. Housing Industry Association economist Geordan Murray says the consumer confidence created by rising property prices provides an important boost for new home building. But weak property prices would hurt sentiment.

"We've seen significant growth in the construction workforce in NSW due to all the residential building that's been going on in the greater Sydney area," said Murray. "If that dried up quickly we would see a rise in unemployment and a greater degree of underemployment." In a worrying sign for the sector, shares in the construction materials giant CSR closed sharply lower last Wednesday after the company said "lead indicators including building approvals are pointing to a softening in activity in residential markets". A lot will depend on how Sydney's households respond to a slowdown in the property market. Rising house prices tend to encourage consumers to spend – economists call it the "wealth effect." But when property values are stagnant or falling, consumers become more cautious and reduce spending. "History would tell you that in the aftermath of house prices peaking, and being flat for a while, there is greater hesitation on the part of consumers about spending," says independent economist Saul Eslake.

Economists also point out that the NSW government is very exposed to a cooling property market. Even if prices plateau rather than fall, a reduction in the turnover of properties means less stamp duty revenue flowing into the government's coffers. Transfer duty accounts for nearly 12 per cent of all state government revenue. "At the moment the NSW government is swimming in stamp duty revenue but the tap can be turned off pretty quick," Dr Oliver says. A slump in stamp duty will, in turn, constrain how much the government can allocate to new infrastructure spending to offset weaker economic conditions. "People worry about the banks and households but it's probably state treasuries that have the most skin in the game when it comes to a housing slowdown," Rawnsley said. Will the aftermath of the boom be as painful as the last one?

In December 2002 I wrote a story for The Sydney Morning Herald with the headline "The boom without end". At the time Sydney property values had been on the rise for six years and the momentum seemed to be building – the city's median house price shot up by more than 20 per cent in 2002. But that boom did end. By early 2004 the property market had run out of steam and Sydney house prices saw a long period of stagnation. Domain Group data shows Sydney's median house price, which peaked at just of $565,000 in the March quarter of 2004, drift down to around $525,000 in late 2005 – a fall of about 7 per cent. The median price did return to its 2004 peak, but not until the September quarter of 2009. That coincided with a period of low growth in the NSW economy. Rising interest rates and a strong Australian dollar contributed to the state's subdued economic performance. But the aftermath of the housing boom was a major drag.

"It ushered in a period of weakness in the NSW economy," says Dr Oliver. A striking feature of Sydney's economy at that time was a dramatic slump in home building. The number of new dwellings completed in NSW plunged from about 45,000 in 2003 to just 26,000 in 2009. The severe shortage of housing supply created by that downturn has contributed to the latest surge in Sydney house prices. To make matters worse, a slump in stamp duty caused by the housing market downturn constrained how much the NSW government could spend on new infrastructure projects to offset the crash in home building. So will the aftermath of Sydney's current boom be as painful?

Unlike 2004, interest rates are now very low and unlikely to rise significantly for the foreseeable future. Unemployment in Sydney is low compared with other parts of Australia and the population is growing thanks to a steady inflow of migrants. That promises to underpin growth in the city economy. A pipeline of major infrastructure projects also promises to offset any softening in the home building sector, to some extent. But there are risks. A significant proportion of recent home buyers in Sydney are investors rather than owner-occupiers. It is unclear how many of them will choose to flee the property market if the prospect of capital gains evaporates amid cooling house prices.

Eslake warns the growing share of investors may have introduced greater instability to the Sydney property market. "The bigger the proportion of the housing stock that is owned by people who don't live in it, the greater the potential for volatility," he says. Also, household debt has reached new highs. Reserve Bank governor Philip Lowe last week expressed his concern about how households will respond to a downturn in the housing market. "Given the high levels of debt and housing prices, relative to incomes, it is likely that some households respond to a future shock to income or housing prices by deciding that they have borrowed too much," he told an audience in Brisbane. "This could prompt a sharp contraction in their spending, as they try to get their balance sheets back into better shape. An otherwise manageable downturn could be turned into something more serious." No one knows when the housing boom will end. But there's a lot riding on how Sydneysiders react when it does.

Housing in the budget This week's federal budget responded to rising voter anxiety over the cost of housing. It included 15 specific measures aimed at "reducing pressure on housing affordability". This included: 1. A tax break for those saving a deposit

The First Home Super Saver Scheme gives first-time buyers a tax incentive to save for a deposit using their existing superannuation account. Contributions will be limited to $30,000 per person and no more than $15,000 can be contributed each year. The scheme starts in July. Treasurer Scott Morrison claims most aspiring home buyers will be able to "accelerate their savings by at least 30 per cent." 2. An incentive to downsize

From mid-2018 those aged over 65 who sell their home of a decade or more will be able to put up to $300,000 in sale proceeds into their superannuation. This incentive aims to allocate housing more efficiently by freeing up more large homes for families with children. 3. A foreign buyer limit and empty home charge

A 50 per cent cap on foreign ownership of new housing developments will be introduced to "safeguard" opportunities for Australian buyers. Also, foreign owners who leave their properties unoccupied for six months will be charged "at least $5000". This levy aims to encourage foreign property owners to rent out their premises rather than leaving them vacant.

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Property investors will no longer be entitled to claim a tax deduction for travel expenses incurred when they visit an investment property they own. 5. A National Housing Infrastructure Facility

A new $1 billion National Housing Infrastructure Facility will fund "micro city deals" that remove infrastructure impediments to developing new homes. This is one of several measures aiming to boost supply, including incentives for increased private investment in affordable housing.