Wednesday, October 31, 2007

Thoughts on housing prices

High housing prices are good.

Well, let me not arrive too far ahead of myself: Indebtedness is a good thing good, and it seems to go hand in hand with higher housing prices.

Hang on. I'm sounding like a neo-liberal! Let me begin afresh.

Low interest rates are great. There we go -- nice, general statement, not going to frighten any horses anywhere. Low interest rates create jobs. They allow entrepreneurs to borrow money to build factories to employ people. They allow hospitals to cheaply upgrade their equipment and allow the best roads to be built. They allow more social goods.

And here we are, well into the second Golden Age, having successfully disinflated the global economy and entrenched low inflation rates. Surely the cause for this was Volker's disinflationary monetary policy of the early 80s in the US, and Fraser's in the 90s in Australia? In part -- no doubt. Though today we will look at the role of the housing market - particularly speculation and asset price inflation in entrenching our low interest-rate environment.

PART 1 - the mechanics of housing price inflation

For this analysis, we'll construct a very, very simple model.

Let us assume housing prices are the product of three endogenous variables: firstly people's savings (which include non-debt proceeds from selling any assets -- ie. asset price inflation); secondly their incomes -- banks will lend more to folk whose capacity to repay is greater; and thirdly, interest rates -- these affect peoples' capacities to repay, and thus have a negative relationship to housing prices in the short run.

Nothing too scary there, and it's all pretty intuitive.

Now, let's look at what happens in the medium run in similar economic situations which we have experienced since 1983 (which we'll assume is the beginning of the modern Australian economy). Nominal wages? up. Interest rates? Tuned for disinflation from 89-92, now pretty steady at 5-7%. Savings? ahah! Read on.

When one goes to the bank to borrow money for a house, they must provide a non-debt deposit. The reason for this is to allow the bank to foreclose the loan if the housing market turns sour, and even sell in a market down 10% (which is rare) to recoup the entire loan sum.

The bank, however will only loan an amount to the prospective borrower which they can afford to repay on their current income (which is, in finance speak, the present value of a proportion of the current income of the borrower for their working lives). Most people, especially in the new economy do not stay on a single income for their entire lives. As they acquire new skills, their marginal productivity increases, and their potential earnings increase. Also, the incomes of society at large increase roughly proportional to the increase in economic activity.

What does all this mean in the real world?

Well, this means that as your income increases, you can afford to comfortably borrow more money, and move into a better house. The thing is, everyone else's incomes have increased too -- the nominal value they can borrow has also increased. So, in a competitive housing market like ours, and with people who all simultaneously want to live in better houses, places, all borrow as much as they can comfortably afford to.

This means housing prices go up. Which is good, no?

Yes and no.

This is a problem which has insiders and outsiders. Insiders, who have some claim on property, benefit from price inflation. The amount they must repay to their creditor stays the same (is not fixed to the property price), though in the conditions outlined above (which lead to increasing property prices), their nominal claim value inflates -- they become wealthier, and their savings increase. When they sell their property to upgrade (having had their income increase, or interest rates decrease), they do not consider the nominal value of the property they intend on purchasing, just the proportion of their current income which must meet repayments.

That is quite peculiar. The rational home-buyer then, must not care how much the property they purchase costs, just the repayment value. If one can afford the repayments on a $400,000 loan, and they have had via this mechanism an increase in their savings of some $600,000 dollars, there is no reason they should baulk at purchasing a $1M property.

For outsiders, though, the picture is not quite so rosy.

While insiders have benefited from society's ability to borrow more (by having higher nominal incomes, from tax credits encouraging speculation, and from the first home-owners' grant), outsiders most certainly have not. Their ability to borrow is only proportional to their income, as they have not accumulated the increase in savings (which, may I add has not occurred due to the home owner's hard work, but the success of greater society), they cannot afford to live in established addresses.

So, that's why Cragieburn exists.

Transitory suburbs, then exist to allow people who have not been long in the property market to live while accumulating an increase in their non-debt savings (using the mechanism described above).

This means that two people on the same income may not be able to afford to live in the same address if they have not made the same real estate investments in the past.

PART 2 - Housing prices and monetary policy

Where is the social good in that? Given there can be two people whose contribution to the economy is the same, and ability to borrow is the same, but who cannot afford to live in the same house, isn't this symptomatic of an entire system which values real-estate speculation above investing in factories, hospitals etc?

Yes. Yes it is. But we have a problem.

If people's income increases more than their productivity, and they don't increase the amount they spend on repayments, we suffer inflation elsewhere. So, to reduce their demand on money (so we can print less of the stuff) we increase interest rates. This makes factories and hospitals more expensive to build. Bugger.

So, people must continually revise upward their price expectations for their houses; they must maintain a fairly constant level of debt as a proportion of their income (and do this by getting into as much as they pay off -- moving into better houses and buying more expensive cars), otherwise the effect of monetary policy (interest rates) on their spending is withered away, and it becomes a less useful tool for controlling inflation.

Here we come to my initial statement: high housing prices are good.

High housing prices, if they occur with high indebtedness, allow monetary policy to do its trick and vary the residential sector's demand for money. But, such prices create losers -- those who cannot afford to enter the market. These people then, are not as susceptible to variance in the interest rate, and will not vary their demand for money as elastically with a marginal change in the interest rate. Monetary policy becomes a larger and larger sledgehammer, to paraphrase Dr John Hewson, being used to tune a smaller and smaller Lamborghini.

PART 3 - The policy response

So, what can we do, in the imaginary world where electoral politics does not exist, in creating a policy platform to maintain the benefits of high housing prices without the huge social cost -- misallocation of capital, outsiders and blunted monetary policy?

Firstly, we would want to attack the non-debt base of the residential housing market. Before I get any death-threats for seeming anti-wealthist, hear me out.

The non-debt base, the 'savings' component of the housing market exists, as we have seen is the reason for the continued increase in housing prices. It is the cumulative amount equal to the entire amount borrowable by the borrowing population in period two less the entire amount borrowable by the same folk in period one (See my website).

As we have seen, people do not care about the actual price of a house if they have already been in the housing market for some time -- only the cost of repayments. So the medium term social costs of targeting this component of housing price would be very little: people will still move to better housing when their incomes increase sufficiently.

The design of such a policy would be a bit harder.

Firstly, its design would have to make specific effort to reducing price inflation by the saving variable, not reverse it. A sensible way for this to be done would initiate a progressively increasing "tax" on all capital gains, which would increase by the amount of the increase in the non-debt savings component each year. This would eliminate possibility of damaging the beneficial price inflation due to income increases or interest rate decrease each year.

Secondly, such a policy must not include a tax - not only for political reasons, but for economic efficiency reasons. It is estimated that for every dollar of an increase in taxation in Australia, there is a 20c "tax and churn burn" in the greater economy, due to the government's inability to behave like a price sensitive business (which it shouldn't have to anyway, just ask Opera Victoria!) A very workable alternative to a tax would be mandating that a proportion of the capital gain (equivalent to that year's "tax") would be set aside to the seller's superannuation, or to be invested in a new equity float or debt capital raising. This would hopefully maintain the seller's overall wealth, but merely transfer some of it into fields where its social benefit would be greater.

The other effect of this policy would be to align housing price inflation with wage growth, and over time eliminating the outsider's effect.

People would still increase their overall wealth, though in a more diversified way, monetary policy tools would become sharpened, and the marginal benefit of being an insider would be decreased, the need to speculate in property would decrease, to everyone's benefit.

Pity is, under the current arrangement, it is so easy for dumb people to make money.

The End.

Please feel free to argue with me