Crampton debates Crampton on the economic theory of landbanking and housing supply
Is standard economic theory a forest hiding amongst the trees?
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Crampton: Property owners will flood the market
Many people think that property owners will flood the market with new homes to push down rents and prices if only they are allowed to by planning regulations.
Eric Crampton, Chief Economist at The New Zealand Initiative, has espoused this view.
For example, he writes about the trade-off owners of feasible development sites face about whether to build housing now or wait for a future period and leave the site undeveloped in the meantime.
He argues that upzoning will create a flood of new homes because waiting gets punished.
If you think council will not zone much more suburban land, you can do well by waiting to develop. Prices will only go up. But there is no point in land banking if everyone expects such a flood of zoned land to enter the market that land prices can only go down.
He also explains here why rising prices increase the value of waiting and can lead to slower new housing development.
When land markets are uncompetitive and prices rise, things get worse. To reduce costs, often urban planning policies further restrict development opportunities. Urban land prices escalate. But as land prices escalate, developers delay bringing homes to market in order to reap greater profits later. A fear of missing out from escalating capital in turn increases demand, creating a brutal dynamic from which only landowners profit.
If only there was a way to convince him that, even without town planning regulations, there is a competitive equilibrium absorption rate that ensures that property owners won’t consistently flood the housing market with new homes and push prices down.
Hang on.
Maybe there is.
Crampton: Property owners won’t flood the market
Luckily, Crampton has also argued that property owners won’t flood the market with new investments to push down the market price of those assets. This was in the context of planting trees to earn carbon offsets in an emissions trading scheme.
The New Zealand Climate Commission was
[…] worried that a surge in forest planting over the coming years would bring about a collapse in Emissions Trading Scheme prices in the 2030s and put New Zealand’s net zero commitments beyond 2050 at risk.
Crampton was quick to assure us that standard economics explains why property owners won’t flood the market by planting trees to decrease the price of carbon credits in the Emissions Trading Scheme.
Which is weird, no?
The same economic logic must apply to “planting” new housing on your property as it does to “investing” in trees on your property.
Let’s find and replace some words — planting for building, trees for homes, etc — in his well-explained article to show why this is the case.
Here’s Crampton’s argument, in (mostly) his own words, against his own argument that upzoning will flood the housing market.
Landowners face timing decisions on whether to build today or wait a decade when considering supplying new housing.
The commission is worried that a surge in housing supply over the coming years could bring about a collapse in housing prices in the 2030s.
It seemed particularly strange for economists who remember Howard Hotelling’s work on the pricing of non-renewable resources over time. It’s standard drill on how to think about these kinds of problems.
Its absence from public discourse about housing prices is hardly surprising – Hotelling is possibly even less of a household name than Armen Alchian. But his work’s absence from the commission’s thinking is a worry.
Howard Hotelling was a statistician who turned to problems in economics.
In 1931, he published work that helped shape how economists have thought about pricing.
His paper, The Economics of Exhaustible Resources, set a simple-looking problem.
Suppose you own a property. It contains only so much potential housing, though you could expend resources to be able to make use of more of it. There are other properties in the world that can also be used for housing
If you own one of those properties, you have to decide how many houses to build today, how much to leave to for the future, and how much to sell of what you have produced.
How should you decide?
After a lot of application of the calculus of variations, which made his work inaccessible to a lot of economists for a few decades, he wound up demonstrating what’s now called Hotelling’s Rule.
To put it simply, the path of prices for a non-renewable resource, like undeveloped property where housing development is feasible, should wind up following the path of interest rates. And it’s fairly easy to see why.
Suppose you could earn $100 by building a house there today. And suppose that interest rates are 5 percent.
If the futures markets say that a house will be worth $102 next year, then you should want to build as many homes today and sell them, rather than wait. If you sell homes today, and put $100 in the bank, you’ll have $105 next year, ie more than $102.
If the futures markets instead said that a house would be worth $110 next year, then you should want to hold back production. The home is worth more unbuilt, with the property available to be built next year, because $110 is more than $105.
As different owners make their decisions, the current and future prices of homes and developable properties change. Whenever the price path expected in futures markets diverges from the path of interest rates, property owners have reason to either build more quickly, or more slowly, to push them back into alignment.
It’s a handy result. Pure profit-seeking by diverse owners leads them to follow a housing supply path that mirrors overall preferences between current and future consumption – the interest rate.
More complicated versions bring in technological change, changes in demand, and changes in the cost of extracting ore, but the core intuition holds. If the mine owner thinks more money can be made by waiting to extract ore rather than digging it up today, balancing expectations about future technology, changes in costs, and interest rates, the owner will do that.
What you don’t see in these models is owners deciding just to dump all of their developable homes rather than holding the properties for later sale despite expecting higher prices tomorrow. Why would they? They would be throwing money away.
There is a lot of land that could be turned into new homes, but that amount of land is not unlimited. Once you turn a piece of land into a home, you cannot do so again.
Land that can be turned into housing can be thought of as a Hotelling-style non-renewable resource.
Just like Hotelling’s land owner, New Zealand’s property owners face timing decisions. If housing stacks up for a piece of land, does it make most sense to build today, or to wait a decade?
Building housing today would mean getting today’s price, but if you think housing prices will be high in the 2030s, it might make more sense to wait. You can keep earning revenue from farming or current property uses in the meantime.
What would make no sense at all would be to build today, take the cash income, if you expect housig prices to be a lot higher after 2050. If you sold the homes early and put the money in the bank, you’d have less money than if you’d just held the undeveloped land to sell when prices were higher.
What a terrific explanation (though I think Harold Hotelling might like the credit instead of Howard).
Here’s Hotelling’s paper for those interested.
Hotelling explains how this inter-temporal economic logic “is characteristic of completely free competition.” My absorption rate model in this paper is a more general version of Hotelling’s model and applies to any market structure where individual property owners face a downward-sloping demand curve.
If competition amongst property owners won’t collapse the price of carbon credits, how can it collapse the price of housing?
The inter-temporal economic constraint always binds.
This logic also implies that it must be possible to regulate the locations where tree-planting for carbon credits is allowed without affecting their price, just as it is possible to regulate where different types of housing can be located without affecting the overall price level of housing.
I don’t know about you, but I find Crampton’s theoretical explanation quite convincing, even if he doesn’t.
Great piece as usual, love the literal tree analogy being used but from someone else.
I think the issue comes back to not the logic of the natural speed limit irrespective of planning controls, but what happens when land is upzoned. There's this weird idea that value of land and the development sites themselves fall upon mass rezoning (I have yet to see convincing evidence from Auckland or elsewhere). In essence saying, currently your plot of land is restricted to a legal tree density of e.g. 1 tree per 10 m2. But if we relaxed that to say 1 per 5 m2 or even abolished the legal limit, what would it do land values and the market for trees?
Of course, the same interest rate logic applies. And as pointed out, you can permit no trees on some land and more trees on other land. End result should be the same. Because it's never been about the amount of trees per plot, but rather the economic constraint binds the quantity of trees in total. And such density constraints could only be effective if they were so strong as to be binding and prevent the quantity of trees reaching the equilibrium with interest rates across the entire market.
Perhaps that's what they believe is happening? But that's the dubious part... That planning is a binding constraint on citywide housing supply.
Interesting piece and it is painful how many in the housing debate do not even seem to want to acknowledge this mechanism. One thing that I wonder about though is whether it matter that the housing market, specifically those who choose to build, are diverse. Big developers certainly landbank, however, there are also 'mum-and-pap'/'leech-off-your-neighbour' landlords (the richer ones) who build 6-10 unit apartment blocks (at least in Brisbane), and I would expect they do not have the same insights into the market and do operate on the same time scale as large scale developers (e.g. they might delay 1-2 years at most). If correct and there are enough of them, they could create downward price pressure, and in turn disincentive bigger developers to landbank. Kinda like a failure of the commons, but by the land-owning class, and to the benefit of the rest of us. Is anything known about this?