Monday, March 22, 2010

Affordable housing supply from a market crash

It seems that no matter what the objective market conditions are like, the same lobby groups (the Housing Industry Association and the Property Council of Australia for example) and property spruikers continue to trot out the housing shortage claim in an appeal for government assistance.

If you truly believed there is a housing shortage and hence an affordability crisis, a market crash (price declines >20%) is the best solution. I will outline my reasoning by referring to the appropriate economic models – the same models misused by those who believe that government intervention is causing supply constraints.

Chris Joye, perfectionist, has lead the charge since the completion of the Home Ownership Taskforce report in 2003, bringing attention to the ‘fact’ that the supply of new homes in Australia is not responsive to price change and it is this phenomena that has lead to such a dire shortage (housing apparently has a low elasticity of supply, even though I have yet to see any quantification of the claim). Instead of producing a solid theoretical argument for his claims, backed up by rigorous empirical evidence, Chris instead repeats the same tired old property industry mantra with renewed vigour and wit.

But what of his ‘elastify the supply side’ solution to housing affordability? (from here)

Economists are also cautious. But Joye says they are wrong because he has plans up his sleeve to increase supply by cutting development costs. There are no shades of grey.

But when pressed he concedes his "supply side" case rests on some tenuous assumptions about the political, environmental and urban planning choices that state governments and local councils are willing to make.

Joye's last line of defence is to press his extraordinary achievements and repeat praise from an army of high-profile backers. But some of the conscripted say privately that their interest in Joye's work has been misconstrued as unconditional support. "Quoting people selectively and out of context is going to land him in trouble," says one who wished to remain anonymous. "You just shouldn't do that."

I agree that Joye’s case rests on tenuous assumptions, incongruous reasoning, and no evidence, and I would second the note of caution on his selective appeals to authority as a defense for his ideas. 

My hesitation rests on the imaginative and unrealistic outcome Joye, and the property lobby at large, suggest - that if only Local and State government planning controls, infrastructure fees, and approval processes were streamlined, developers nationwide would be happy to build and sell more new homes, at lower prices.

Sure, that will happen.

And of course, the supply side has been the problem the world over. Hang on, except in Germany where strict lending standards and tax regimes rule out speculation on property prices- though they must have particularly lenient planning controls to keep prices so stable (see an international comparison of price-rent ratios in the figure below).

For those with common sense, we can simply say that if constraints on supply (of which there are none) caused Australia’s property boom, what on Earth caused the contemporaneous housing booms the worlds over? Oh yes, supply constraints irrational bubble investment fuelled by exuberant lending.

Spruikers, please don’t invoke the population growth argument now, or you’ll be asked to defend this argument for property markets around the world, and you know as well as I, that the argument is fallacious.  Population growth can only drive up prices if the new people are willing and able to pay higher prices than the existing population. 

Joye takes his analysis a step further than his predecessors by appealing to the mythical cross swords of demand and supply, a model we all learn in first year economics, yet generally one we fail to completely understand.

For those without an economics background,

1. The economic model where supply responds to price describes consumption goods over the ‘short run’ – a period of time so short that new capital investment cannot be undertaken.

2. The model does not apply to asset prices (remember that land prices, not construction prices, have increased dramatically this past decade) – asset supply, in the form of capital goods, should not be responsive to price, but can be responsive to returns and their associated risk (the price of future productive capacity of the asset).

3. Even if we assume that the above two points are wrong, a declining housing price will not reduce the supply of homes, but will allow prices to ‘reset’ and price growth from this lower base will continue to stimulate supply at a lower price.

But let us examine the three points above as a refresher in economic theory.

Most people with an economics degree still fail to make the (dis)connection between reality and the upward sloping supply curve of classical micro and macro theory. The only reason the supply curve is upward sloping, and hence supply should increase as a response to price, is that businesses are operating at the extremes of their capital capacity – so much so, that the cost to produce each extra good is in fact rising, rather than falling (increasing marginal costs as it is known). But how much does that reflect reality? Simply put, it doesn’t 99% of the time. It is rare that businesses will fail to respond to a situation in increasing marginal costs by not increasing their capital base in the longer run.

If we glance now at point number two, we can further see the absurdity in Joye’s supply elasticity argument. Supply of a given asset does not need to respond to increasing returns – prices can simply rise instead. If asset supply did respond in such a way, we would never see capital gains on the share market, as supply of company shares would continue to be increased in response to minor price changes.  However, in the property context, it is higher rates of return that will increase supply, which can only come about from higher rents, or lower land prices.

Finally, if we ignore all the arguments I have already made, and assume that supply of new homes is indeed responsive to price, then the best way for governments to ensure a high rate of new dwelling supply is to let prices fall. When prices fall, development sites will be forced onto the market and snapped up by buyers at prices far below those paid by their previous owners. These new buyers will be able to profitably build new homes at prices below those seen prior to the crash. We can reset the market at 20% below current prices, and have supply stimulated from that new low price baseline.

The supply elasticity argument fails on its own grounds, and on more rigorous theoretical grounds. Like my previous arguments about subsidizing farmers to protect food supply, subsidizing developers to protect housing supply is the worst move a government can make.  Letting asset markets reset (clear) is the best way forward.


  1. Boring. This is a personal attack that detracts from what are sometimes good ideas. You do yourself a disservice. In my readin, Chris Joye is a national treasure.

  2. Great analysis! A stress free way to dealing with reality. Thanks for the insights. By the way, if you're looking for the most reliable real estate people to help you with your property in Australia, then I've found the best one for you. Good luck!

  3. Hi Cameron, another good article.
    It will be interesting if somebody can compare us to the Canadian market. A report of that market can be found here:

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  5. Richard. Appreciate your thoughts. The third paragraph may be a little personal (I have now toned it down a little) however the point is that Chris needs to thoroughly think through AND demonstrate his ideas. He is getting a healthy reception from many areas of government and private enterprise for his supply side argument, yet we have seen no actual evidence (statistical analysis, natural experiments and comparisons?) for his claims.

    My appeal to natural experiments where the State has intervened to encourage housing developments, show no signs of impact on regional housing affordability (from here )-

    Springfield, to the west of Brisbane is only 13% developed. It has an area of 2,860Ha, and a target population of 86,000 people, with house and land packages available now. Coomera, north of the Gold Coast, has been rezoned for a new satellite city, and has very good highway access to both Brisbane and the Coast. Land is zoned for housing for an estimated 60,000 people. Sippy Downs, west of the Sunshine Coast has a new plan promoting development around the University of the Sunshine Coast. Not to mention infill projects such as Portside in Hamilton, and the ongoing transformation of Teneriffe, South Bank, and South Brisbane into dense residential areas.

    Darren, it seems like there a many similarities between Australia and Canada - massive government support including opening the market to foreign buyers, and stimulating sub-prime lending (strange idea to me) - I didn't notice if they'd also tried a FHOG. A correction appears likely however the timing and severity still in question.

  6. I'm only familiar with Christopher Joye via his home equity scheme, designed to "increase affordability". How on earth anyone can believe that giving everyone extra purchasing power in the housing market will make houses more affordable is beyond me. Either the guy completely misunderstands economics, or, more likely, he understands it all too well, and has some vested interest in inflating the property bubble. I suspect the latter.

    Cameron, your argument is correct. The only way to make houses more affordable is for the price to come down. The federal government banged on and on about housing affordability in the 2007 election, but have thrown billions at trying to keep the bubble inflated; and are quite proud of their success. We can only hope that they run out of money or motivation to continue the charade soon.


  7. Much Better CM. I don't agree with your analysis however. Joye provides much analysis on his supply side arguments in his long report to the Prime Minister in 2003 that was authored with Glaeser from Harvard. Sure you are familiar with Glaeser's work.

  8. Richard, yes, the 2003 report to the Prime minister (the supply volume) is linked here

    My point is that in the whole volume rests on an inappropriate appeal to economic theory (from page 270):

    One of the fundamental implications of modern economics is that in an open, competitive, and unregulated market, the price of a commodity should not be greater than the marginal cost of producing it. If such an inequality did emerge, suppliers would have strong incentives to manufacture more of the goods in question. Sooner or later, competition amongst agents would ensure that prices converged with their marginal costs. This logic holds as strongly for Australian houses as it does for meat pies.

    This is incorrect for the 2 reasons I note in this post (the third only applies if you believe that the demand-supply comparison applies).

    Figure 83 on p287 also demonstrates how responsive housing supply is to minor price changes.

    Glaeser proposed in 2005 that inflated UK house prices were the result of NIMBYism and planning regulation. He said the same thing about Manhattan real estate in 2004. I wonder how he explained the price declines seen recently in both of these markets?

    To demonstrate that land taxes, stamp duties, and cumbersome and expensive development approvals are to blame, all you need to do is compare the price of land in two local government areas where there are major differences in these factors. For example, Ipswich City Council is typically faster, simpler and cheaper for development approval compared to Brisbane, yet has seen the same (if not greater in percentage terms) land price growth as neighbouring areas.

  9. Cam, Although I believe housing and property is overpriced in Australia, I don't agree that a market crash (>20% decline) would help increase housing supply as you argue here.

    The problem with your reasoning is that if prices did indeed fall >20% I doubt you would find many developers/investors willing to build housing nor banks willing to lend. Markets tend to move based on sentiment and recent history of prices definitely weighs on sentiment. The fact that many prices have remained relatively robust in Australia despite the downturn, has added fuel to the bubbles fire in my opinion.

    To explain my point, in booms lending is easy and this fuels growth and investment, in a bust, lending is tight and this emphasises the downturn. It is not only interest rate (price of money), it is the willingness of investors to invest and banks to lend. Call it what you will but this market sentiment seems not to be captured in economic theory or maybe it is irrational behaviour that is assumed away... But from what I have seen in real life in the UK: In 2007, I could easily have drawn a mortgage with maybe 10% deposit and a competitive (margin) interest rate. Now, I would struggle to get a competitive rate without 35% deposit, and would struggle to get a mortgage at any rate without at least 20%. This despite the fact that interest rates dropped from ~4.5% to 0.5%

  10. Christian, it's all in the timing. While yes, there will be a temporary decline in construction, new buyers of development sites will be able to bring housing onto the market at lower prices than today once the decline is arrested. There are developers out there with cash to spend who don't need to borrow for a new development sites.

    You can even develop housing in a declining market if you have factored in this decline into the price you pay for the land.

    Some developers with large land banks will even be forced to keep putting housing (and land) on the market in a downturn because it is a far better alternative than letting its value continue to decline, and they need cashflow to stay in business.

  11. Cam, thanks, I see your point, but I believe that due to the leveraged nature of the property market any fall in the region of 20% is likely to bring more sellers (forced?) to the market than buyers especially if the fall starts from a highly inflated peak. Maybe in the long term your theory would play out and the market would be better for it, but the short term pain of the voting public with mortages would demand political action/spending/bailout to resolve.

    In my opinion - expectations and sentiment drive prices. Even if a price has fallen, I will wait to buy if I believe it will be cheaper in 6 months. This is why deflation becomes a self fulfilling phenomenon. The reverse is also why a controlled level of inflation in any market is required to encourage investment and development.

  12. The theory that inflation is required to encourage investment is a simplification of a very complex phenomenon. Consumer electronics is the best counterexample. The price continues to deflate, and yet more and more people continue to buy, and more and more companies continue to invest. The industrial revolution occurred without controlled inflation (in fact, it actually caused price deflation), and the technology revolution would have occurred without it too.

    A deflationary scenario will indeed lead to a difficult period, but nobody could seriously believe that it would continue forever... would it continue until we have things priced at fractions of a cent? It doesn't take too long until the people who saved see their purchasing power increase, and start spending again.


  13. But Tim, consumer electronics and housing are different types of assets. I believe that price deflation in an asset market such as property where many buyers are highly leveraged households would be pretty ugly. Not many people take on a loan of 3+ times their income to buy a computer. The fact that a very large proportion of australian households are highly leveraged against the value of their house makes this a very sensitive political topic. I am not saying it would continue forever, just that in my opinion, if it did happen I anticipate government intervention in some way due to its political sensitivity.

  14. Christian, I agree with you 100%.. They are different markets and deflation in the housing markets would be painful while it lasted. However, this is no reason to try and re-inflate it. The cause of the woes in the US is not deflation. Deflation is the symptom. The cause is the credit inflation that occurred during the 10 years prior. A lot of people (politicians, central bankers, economists) are wrongly attributing the economic problems to the sub-prime housing crash, but it was the sub-prime (and prime!) lending that caused this problem. The cure is to let the deflation occur. Unfortunately, as you say, governments will not let this happen, and will try and fight it -- see the first-home buyers grant extension that the Rudd government introduced. Ultimately, they will fail, because they simply cannot prevent the de-leveraging, but they will destroy a lot of real wealth in the process.


  15. anonymous - the US problem was caused by sub-prime which caused contagion in the housing market, which in turn caused contagion in the banking sector.

    None of that happened here. Even in the UK where prices fell, we are seeing prices tick back up again.

  16. Peter. The US problem was caused by lending people more money than they could afford -- both prime and sub-prime borrowers. "Contagion" would otherwise not be a problem, and is largely a concept invented by economists who failed to see the GFC coming. If I'm a prime borrower, why would it matter whether a sub-prime borrower could not pay their mortgage? It isn't -- unless I can't afford to pay mine either, and I have been using equity to pay for other essential costs because my mortgage is chewing up large amounts of my income.

    As for the UK market... we are seeing prices tick back down again there now, even with the massive government support being given to the market. Both in the UK and here, people were given mortgages that they could not afford. I'm sure you recall the squeals of pain when the Reserve Bank were lifting the OCR in 2008. Unfortunately, their only response is to try and blow up the bubble again. How long can they continue doing this? I would say that our day of reckoning will arrive soon.


  17. I went to school with Christopher Joye and he is a genius.