Thursday, 13 November 2008

Perverse incentives and the housing market

Housing in Australia is very expensive at the moment - I think there is no question of that. Compared to incomes, it is amongst the highest in the world.

Why is that?

Most people would assume that it is a byproduct of an economic boom. If the economy is doing well, then house prices must go up as people get wealthier.

Have a listen to this podcast at Counterpoint and then see what you think.

In my opinion, one of the drivers of the increase in house prices has been a wall of money that has been unleashed by the banks and the non-banks. When a growing amount of money is chasing a fairly static number of assets, the price of those assets will go up. If houses are thought of like any other asset - gold, shares, bonds, silver, collectible art, racehorses, tulips etc - then it becomes clear that we're at the top end of an asset price bubble. If you want to read a lot more about this, go to the UK Bubble blog - it makes for excellent, if slightly depressing reading. I read it every day before going to work - it stimulates me to go and make money, because we're going to need as much of it as possible to survive the efforts of "fumble fingers" Woin Swan to "save" the economy. Watching Woin trying to do that is like watching a headless chicken with its arse on fire running around inside a gunpowder mill.

The podcast made some interesting points which I will elaborate on.

The first was the incentives that town planners face in different countries. The second is that in the US, those regions that had the strictest land use regulations also generated the highest number of sub-prime loans.

Think about how councils are financed in Australia. They get some money from rates on land, and the rest in grants from the state and federal governments. Some money also comes in from processing fees and the like.

The incentive for all councils is to increase the value of the land within their boundary, which will feed through into higher rates and thus a fatter council budget. They are not interested in stable land values, and are terrified of declining values. It is therefor in the best interests of councils for them to do all that they can to pump up land values. An asset bubble is good for them.

What is the best way to increase land values?

Apart from initiating a wall of money via cheap and easy credit, the other way is to restrict the supply of land. This is where planners come in.

One thing that was mentioned was that in Switzerland, local government levies income taxes. This means that councils have an incentive to attract more people (at least more people that earn enough money to pay an income tax), so planners plan in such a way to entice them in.

It's interesting to contrast that with the recent view of Michael Costa, who said that Bob Carr essentially wanted to stop Sydney from growing at all for green reasons. When you combine state government pressure to stop land releases with local government incentives to boost land prices, you get the sort of stupidity that Sydney has been going through for a decade. Many people think that they are very smart because they have made money out of the housing boom (or house price asset bubble as I prefer to call it). They're not smart - they're just fortunate to have bought at a time when a convergence of forces relentlessly drove up prices.

The other bit that was interesting was that about the relationship between land use regulation in the US and sub-prime lending. In Australia, we get the impression that "sub-prime" meant lending to poor people with no money. That's part of it, but there were also a lot of very large loans (in the millions of dollars) to quite wealthy people who were either speculating in the market, or buying not just a big home, but a grandiose home that would normally have been beyond their buying power.

Land use restrictions clearly acted to drive up prices. When housing starts to become unaffordable with a normal, prudent loan, some people will do the obvious thing and take out a bigger loan than prudence would dictate in order to buy something. The old rule of thumb is that your mortgage should not exceed 3 times your gross income. If you earn $100,000 pre-tax, you limit yourself to a $300,000 mortgage.

But let's say you are earning $100,000, but a house in your area now costs $700,000, and you only have a $100,000 deposit. You go sub-prime, and borrow $600,000 (well, more than that, since you also need to pay stamp duty and conveyancing etc). Not many poor people were borrowing that sort of money - you need to be fairly well off to be doing that; but that's what a lot of people did, in the expectation that either their incomes would go up (due to a booming economy) and/or that house prices would go up, thus giving them a gain if they were forced to sell.

Gee, aren't those people fucked now.

One thing that is clear to me is that if we want to stamp out all these NIMBYs and do-nothing councils, we need to change the structure of incentives that councils operate under. That probably means overhauling how they raise money, and unfortunately I can't see that happening in my lifetime.

In other words, we can look forward to a few more booms and busts in my remaining lifespan.

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