In defence of simplistic models

This post on methodology is related to recent discussions about the role of maths in economics (Matt has a good summary with the relevant links here), but is actually response to a comment by Chris B over at SciBlogs to my initialpost on Labour’s proposed ban on non-resident ownership of houses. (Yes, this post is long overdue. Events have conspired to keep me away from blogging for a couple of weeks.) 

Chris says: 

You know, the more I think on it, the more dissatisfied I am with this thought exercise. If only because Seamus has seen fit to call it a “very simple model of the New Zealand housing market”. It realy isn’t . It’s simply a fictional market with certain highly abstract asserted properties. No more realistic or useful than the various maths exercises from my own university level economics classes.

Fair enough. I should have said a simple model to help think about the New Zealand housing market. The point of this post is to ask whether simplistic models can be useful. Note that such models are unrealistic by design. If I were writing an academic paper, I would have used a much more complicated model, and if writing a problem set for an undergraduate class, something only a bit more complicated. But this was a blog post, so the model was designed to be easily solveable in your head. (I hope that the maths exercises from Chris’ university-level economics classes were more involved than this one; if not he was severely short-changed by his university.)

In general, a simplistic model is designed to make one or two points by stripping away every piece of reality except a specific thing that you want to highlight. Some of the assumptions one makes in doing this are simply removing irrelevant reality in order to focus attention on the key aspect of the question at hand. Others are more like dogs that don’t bark in the night; seeing what happens when you assume away some aspect of reality highlights how important that aspect is. Chris lists a whole bunch of assumptions in my model. I won’t go into these in detail, but I would argue that they all fit into one of these two categories. Some, like the assumptions about homogeneous preferences and housing quality are just assuming away irrelevant reality. Others, like the assumption of inelastic supply are non-barking-dog assumptions. As I noted in my original post, when you relax this assumption, you make the case against bans on foreign ownership stronger. 

The realism or lack thereof of a model is therefore not a criterion for judging a model’s success. A simplistic model can be criticised for one of three reasons: 

a) the intuitive point that is laid bare when all other reality is stripped away is so obvious that the point doesn’t need to be made;

b) the model doesn’t actually illustrate the point being made; or

c) the point is actually wrong, and the model fails because it stripped away some highly relevant aspect of reality.

The third is not necessarily a criticism. If a model’s intuition can be changed by adding in some relevant piece of reality, the process of starting with a simple model and then relaxing the assumptions lays bare what the crucial step is for generating a particular conclusion and informs where one needs to look for empirical evidence supporting it.

Now, in my post, I was looking to make two points: The first was that the price of houses depends on the current and future expected stock of houses and the current and future expected demand for housing (i.e. the willingness of people to pay to live in houses); changing the rules on who is allowed to be non-occupier owners of houses should not change the price of housing absent a mechanism for the policy to affect demand for occupancy or the stock. The second point was that if speculation is pushing up the price of houses, it is only because house prices are expected to increase in the future; attempts to restrict speculation without dealing with the underlying drivers only delay the issue.

Now I don’t think you can say that my model fails on the ground of being too obvious, as so much public commentary on housing policy simply routinely ignores these two points. Whether the model is successful in illustrating the point is very much in the eye of the beholder. For the third criticism, I certainly can imagine relaxing assumptions to generate different conclusions and inform a debate about what is the more likely state of the world. Chris, however, would prefer to eschew the simplistic model altogether. In his words:

Plainly the exercise does not remotely resemble the New Zealand Housing market. Why, then, should we have any particular faith in our ability to extrapolate from the though exercise to what will happen in the real-world economy.

In what sense does the model not resemble the New Zealand housing market? The model has both renters and owner occupiers. It has owners of rental properties who earn investment income from the ownership. It has a future expected increase in the demand for housing, and in that world has landlords earning a below-market rate of return. All describe exactly, say, the Auckland housing market. Yes, the real-world economy has other things as well, but it is important to understand the simple models before adding complications. What is the alternative?  Chris’ conclusion is as follows:

Perhaps a better approach to arguing against the policy on economic grounds would be to identify other places where it has been implemented and talk about the impacts which have resulted. Potentially tricky to isolate the impacts of the policy from other confounding factors, but if it can be done, there’s the advantage of being able to present some empirical evidence against it. 

 Alternatively, perhaps we might drop the thought exercise entirely as extraneous and talk specifically about how we expect foreign buyers will react to future restrictions on their activities, consequences for investment decisions and the like.

Not so fast. How do social scientists isolate impacts from confounding factors? They use theory. That is, they have a model or competing models in mind that would be consistent with some observed correlations but not with others. And how can you learn anything about how foreign buyers will react to restrictions on their activities and what impact that reaction will have for the housing market, if you don’t have a view about how their behaviour relates to conditions in the housing market, how other people will respond to that reaction, etc.? 

In other words, careful empirical and behavioural analysis rests on models, and complicated models rest on simplistic ones. Non-careful analysis, in contrast, rests on unstated models, models that are potentially self-contradictory or rest on assumptions that have assumed away relevant reality but have never been made explicit. 

Reader mailbag: LVR edition

A loyal reader writes, and I anonymise:

My [partner] is a [high ranking title] at [large professional services firm] and over drinks last night the young [professionals in this industry] (under 28, mostly single, still have student loans, gross income btw 60k and 90k, most 2/3 years’ experience max) were crapping themselves re the RB’s loan restrictions…really pissed about it. Most had planned to buy modest apartments this year using KS… centrally imposed adverse selection bars have costs! I said to go to Mum/Dad and/or finance houses, get a mortgage and then fold the other debt into after a year … impossible to police?

Yes, it is impossible to police. And that's a feature rather than a bug, if the point of the Loan-to-Value Ratio regulations is to increase the amount of collateral standing behind each home loan and thereby reduce systematic risk that could come from a housing downturn. If every one of these young professionals gets their parents to take on some of their mortgage risk by backing it with their own homes, which is effectively what they'd be doing if the parents take out a mortgage to front a 20% deposit, then the kids are less likely to default on the loan to the bank in case of downturn, though they may default on Mom and Dad, and the parents may be on the hook for some unexpected mortgage costs. But that has lower systemic risk. RBNZ noted it in their initial paper too: these workarounds are hardly unanticipated, and I don't think they're unwelcome. They work around the regulations in ways consistent with what the regulation should be trying to achieve.

My correspondent wonders further about effects where some young professionals have recourse to Mom and Dad and others only to the finance companies. I expect here that it has strong equity effects, but the efficiency effects still work in the right direction. Borrowers on the secondary loan market will be paying higher interest rates and so we still see a reduction in demand for highly leveraged loans at the margin. The ones most hurt by the regulations are indeed the ones with least access to family or other capital. But equity isn't RBNZ's job, and those would be the riskiest borrowers in any case - the ones that RBNZ is deliberately trying to knock out of the market.

The bigger problem is the one Matt Nolan points to: RBNZ is grasping at all kinds of justifications for its regulations, and some of them either are way outside of anything RBNZ should be doing, or just don't make any darned sense. I can see some kind of case for it on systemic risk, but I would bet against the regs being justifiable on that basis. Default and bailout risk under OBR is lower than it was prior to OBR. And RBNZ simply should never ever be in the business of trying to protect investors from the risk that their investment might decrease in value. They don't have that kind of crystal ball.

And if the regs don't make sense on a reasonable rationale, we might start worrying rather more about the equity considerations.

In which we welcome Shamubeel Eaqub and revisit an old chestnut

The excellent Shamubeel Eaqub is now blogging as part of the team over at TheVisible Hand of Economics. Shamubeel has been a regular commenter at TVHE and is often quoted in the media; it is great to see him now blogging. Eric linked to Shamubeel’s first post yesterday in his Monday round-up.

Shamubeel was commenting on this story about National’s latest housing policy, in which “the number of first home buyers eligible for KiwiSaver deposit subsidies will double”, but buyers “will have to save a bigger deposit before they qualify for Government assistance”. Again, I find myself asking, What is it about housing policy that leads to people forgetting basic economic principles? The two quotes that jumped out at me were the following:

"Key said the requirement for a bigger deposit was necessary to avoid throwing fuel on an already overheated housing market in Auckland."

And David Shearer’s

"I am also determined to reduce speculation-driven demand in our housing market. Labour will restrict sales to overseas speculators and clamp down on speculators here through a capital gains tax on houses bought over and above their own home."

So Shearer  wants to make housing more affordable partly through taxing it and partly through a policy that restricts the nationality of who can own a rental property but won’t affect the number of people wanting to live in houses or the number of houses available for living. I have discussed these ideas before (here and here) so won't belabour the point. But now Key wants to join the party by promising to make housing more affordable by simultaneously shifting the demand curve to the right and then shifting it back to the left to prevent price increases! For sheer internal inconsistency, you have to say that National’s policy takes the cake here.

To be fair to both parties, both are also offering solutions to act on the supply side as well. And both parties think the other’s policy is crazy, so they have that right as well. But it wouldn't it be great if we could get beyond these silly games and have the political discourse focus on real policies?

Affordable Housing: Five Basic Principles

What is it about housing policy that leads to people forgetting basic economic principles? Following on from the extraordinary Labour Party policy that Matt and I jumped onat the start of the week, we had this blog post from Susan Guthrie, and thispress release from Labour. Matt has commented expertly on these here and here, and I don't want to beat a dead horse. But in all the discussion about housing in the blogsphere, a few basic principles keep being ignored, so I thought I would finish what has turned out to be housing week in the blogsphere by listing those prinicples in one place: 

1. The price of housing depends on the supply of available houses and the number of people wanting to live in houses coupled with their willingness to pay for housing. The price of houses depends on the price of housing today and the expected price in the future. Policies that affect who ownshouses and the incentive to purchase existing houses as an investment are sideshows unless they change the underlying stock or the underlying demand for housing. 
2. Speculation works by buying assets when their price is expected to rise and selling when the price is expected to fall, thus reducing price volatility. Speculative investment that increasesvolatility in house prices is investment that loses money. If such speculation were coming from overseas, it would be a source of income to New Zealand.
3. Speculation that leads to an increase in house prices and makes money, is only profitable because underlying factors are operating to push prices up even further in the future. Any policy that claims to be able to reduce house-price inflation by restricting speculative investment, is a policy that is an open admission of having no solution to the long-term problem.  
4. Policy can reduce the demand for housing or for houses by imposing taxes, but that can only lead to a reduction in the before-tax price not to the after-tax price and hence is not a route to making housing more affordable.
5. More specifically, there is a tax advantages to owner-occupied housing over renting. But to the extent that has any effect, it leads to too much investment in creating houses and hence to lower house prices than would otherwise be the case. There may be arguments for eliminating the tax preference, but affordability is not one of them. 

It would be nice if the main-stream media were to ask questions of politicians rather than just disseminating their press releases. Asking them to explain their policy proposals in light of these basic ECON-100 principles would be a good start.

Labour on Housing, RBNZ on LVR

There appears little plausible economic justification for Labour's proposed ban on foreigners' buying houses.

Let's take Seamus's logic from yesterday one step further. Recall Seamus's simple model:

Consider a very simple model of the New Zealand housing market in which there is a fixed supply of identical houses that will not change over time, and an unchanging demand. Let there be no on-going maintenance or other costs to owning a house, just the one-off capital costs. Finally, let there be a risk-free interest rate of 5%, let demanders be risk-neutral and indifferent between renting and owning for a given cost, and let rental income to a landlord be exempt from tax so that there is no tax advantage to owner-occupied housing. In this world, there would be an unchanging equilibrium rental price for housing over time, and an unchanging price of houses that would be equal to this rental price times 20.

Following on from Seamus's later tweaks to the base model, let us also change the model a bit. Imagine that demand in one year's time will double and then stay constant from then on, and that everyone knows that as of tomorrow. The process is identical to the one Seamus lays out for the case where only foreigners know that equilibrium demand doubles in a year's time given that the stock of foreign capital is large relative to the domestic market:

In this version of the model, the rental rate would continue to remain constant for a year before doubling, but foreigners would bid up the price of houses now to the point where the capital gain between now and in one-year’s time was sufficient to exactly offset the fact that current rentals are insufficient to cover the capital cost of the house.

We can get a disconnect between current rental prices and current house prices where the market expects a future increase in demand relative to supply. That rental rates have not gone up lock-step with Auckland housing prices simply isn't automatically evidence of a bubble or anything irrational. Rational, forward-looking investors could easily be looking at the current Auckland market, the current plans for expanding housing supply in Auckland, and concluding that there's no way that supply will increase quickly enough to keep up with increases in demand. We can't guarantee that this is what's happening, but we cannot simply look at the purported disconnect between rental costs and property prices and conclude BUBBLE.

Now, consider the RBNZ's proposed LVR policy. The policy restricts banks against allowing more than some percentage of new home mortgage loans to have "small" deposits. I am not sure if RBNZ has yet indicated what the thresholds for the different speed limits will be, but it's sounded like it's designed to be binding most of the time. Under what scenarios does this rule make sense?

Start with a world like Seamus's: perfectly inelastic supply, prices 20 times rental rates under his conditions. Further, there is zero chance of bank bailouts in case of property market collapse; everything would be handled under OBR where depositors might take a small(ish) haircut. Individual investors form expectations about future demand; banks form estimates of the future price paths of housing. They're both identical in this simple case. Now, suppose that a cohort of buyers knows that demand will double next year and so start bidding up the price of housing today. The banks from whom they're borrowing money check to make sure that the buyers will be able to cover the mortgage costs and that the buyers' expectations around future rental earnings aren't crazy.

In this world, LVR restrictions only make sense where bank exposure to highly leveraged property loans impose systemic unpriced risk. Even if RBNZ knows no better than do individual banks, they might want to set speed limits where loans risk pushing into leverage levels consistent with prior cascading bank failures. I'd expect that RBNZ has run plenty of stress tests and has some idea of what level of leverage could yield cascading failures for varying levels of property leverage and plausible ranges of housing market drops.

But, in this world, you only set the speed limit to bind in exceptional cases, not in normal cases. To get a rule that binds more strictly, I think you have to assume that RBNZ knows more about the future path of relative demand (either shifts in demand, or potential moves in the supply curve) than do either the banks or investors.

I wonder whether Labour's "dey turk er houses" ban-the-foreigners housing policy shares some common assumptions with RBNZ's LVR regs. Tweak Seamus's model a little bit such that these foreign investors are all just systematically wrong about the future demand path and that there are enough of them that they can manage to affect prices at the margin. Then banning them from bidding up housing where we know that they are causing a bubble by definition avoids a bubble. I do think this requires some pretty heroic assumptions about knowledge asymmetries. But they might not be all that far from the knowledge assumptions required to make sensible an LVR policy that binds in the normal rather than only in the exceptional case.

Labour's Housing Policy

I am baffled by the Labour Party proposal to ban foreign speculators from owning houses in New Zealand. O.K. that is not strictly true; as Matt over at TVHE notes, the policy is easy to understand as a cynical appeal to xenophobic New Zealand First voters. But David Shearer is a better person than that, and so I would prefer to remain baffled and try to think through the logic of the proposal.

Consider a very simple model of the New Zealand housing market in which there is a fixed supply of identical houses that will not change over time, and an unchanging demand. Let there be no on-going maintenance or other costs to owning a house, just the one-off capital costs. Finally, let there be a risk-free interest rate of 5%, let demanders be risk-neutral and indifferent between renting and owning for a given cost, and let rental income to a landlord be exempt from tax so that there is no tax advantage to owner-occupied housing. In this world, there would be an unchanging equilibrium rental price for housing over time, and an unchanging price of houses that would be equal to this rental price times 20.

Now change the model a bit. Imagine that demand in one year’s time will double and then stay constant from then on, but that will not be known in the one year before the change. In this world, the equilibrium rental price and the equilibrium house price will both double in one year’s time and current owners of houses (both owner occupiers and landlords) will receive a one-off capital gain at that time.

Now make one more change. Imagine that the future increase in demand becomes known now, but for some reason only known only to people who are not citizens or permanent residents of New Zealand or Australia. In this version of the model, the rental rate would continue to remain constant for a year before doubling, but foreigners would bid up the price of houses now to the point where the capital gain between now and in one-year’s time was sufficient to exactly offset the fact that current rentals are insufficient to cover the capital cost of the house.

Now compare this model to the one where the demand increase was a surprise to everyone. Renters pay exactly the same amount of rent in each period, owner occupiers receive exactly the same capital gain, but can realise it's present value straight away. Foreign speculators receive only the market rate of return on their investments, just like any other inflow of capital that allows New Zealand to fund investment in excess of its saving. The only distributional effect would be a shift in the capital gain from those who would have bought houses during the year before the demand increase to those who would have sold, but there seems no particular reason for policy to favour one of these groups over the other.

In this world, it is hard to see what possible benefit there would be to a policy of banning overseas speculators from owning houses, which is what Labour are proposing. Of course, the assumptions in these three models are extremely unrealistic. So what changes to the model or what welfare function can make sense of this policy? We could relax all the assumptions about indifference between renting and owning, risk neutrality, homogeneity of the housing stock, no tax advantage to owner-occupancy, and no other changes over time, but it wouldn’t change the basic intuition. We could assume that supply is not perfectly elastic, but that would imply that the earlier rise in price from speculation would generate an earlier supply response and hence more housing affordability. And we could assume that, maybe, New Zealanders and Australians know at least as much about the New Zealand housing market as non-Australasians and so can bid up the price of housing without overseas help, in which case banning foreign speculators would have no effect at all.

It is easier to make sense of other parts of Labour’s housing policy. Building 100,000 houses would obviously reduce prices if it added to rather than displaced construction that would otherwise occur, although the policy is silent on how it would find the land on which to build the houses given council zoning restrictions. Similarly, a capital gains tax that excluded the family home, while doing nothing to change supply and demand, would be a way to reduce prices to owner occupiers while increasing prices to renters. Such a policy proposal wouldn’t make much sense from a party representing lower-income households (who are more likely to be renters), but it is perfectly consistent with a party that proposed exempting fresh fruit and vegetables from the GST.

But Labour’s Press release focuses mostly on speculation. The point needs emphasising: speculation that pushes up prices is only profitable if those prices were going to increase anyway for non-speculative reasons. Preventing speculation (if it were possible to do so) only delays the eventual price rise. Doing something about the future price increases by addressing supply constraints would not only be a long-term solution, it would remove the incentive for speculation at the same time. In other words, any politicians whose housing policy consists mainly of an attack on speculation is essentially conceding that they have no long-term solutions at all. 

Housing daily: LVR, NIMBYs, and congestion charging

The RBNZ will soon announce its Loan-to-Value rules. Matt Nolan makes a few reasonable points (all my paraphrasing):

• If the policy is targeted at financial stability, then it has to bite on high-leverage first home loans as those are the most likely to wind up in positions of default. 
• I'm still a bit sceptical here as the OBR rules mean that the banks have to burn their equity holders and unsecured creditors before touching depositors if they make a bunch of really risky loans: I'm just not convinced that the banks here are really imposing systematic risk by allowing highly leveraged loans. But maybe the RBNZ has insider information suggesting that the government is way more likely than anybody thinks to start stomping on Councils' NIMBY regs currently preventing new building and so property prices are set for an unexpected fall.
• Further, the choice of "speed limit" will matter. Suppose we've had a road with no speed limit and we're promised one will soon be implemented to stop speeding-related risks. If they then announce a highway speed limit of 100 or 110 kph, that's all fine. If they announce a highway speed limit of 25 kph, not so much. I don't know what fraction of normal-conditions first home loans would be blocked under the new rules, so I don't know whether we're setting a 100 or 25 kph speed limit.
• Politicians mucking about with what the RBNZ is proposing risks undermining the whole purpose of the thing.
• I expect here that Matt's alluding to some of John Key's comments suggesting that first-home buyers be exempted.
• Politicians seem to see LVR as a way of fixing housing affordability; it's not well-suited to that end. 

  At the moment political parties want to loosen financial conditions for home owners, and introduce all sorts of schemes that will get capitalised into house prices.  Instead, the politicians should be looking at it as a distributional issue – it isn’t about giving young households cheap large houses that only exist in fantasy, it is about being realistic about any intergenerational distribution issues that we believe exist due to the inherent “cause” of the current “bubble” or a broader “misalignment” – this has to be relative to what we think is “fair” around the distribution of lifetime resources.  We can’t just “pop” a bubble, but if we understand the causes we can deal with the distributional issues associated with it.  Looking at supply side constraints (which both parties are) makes sense – good to see that.

  But what about the near term?  Worst case scenario, one-off tax all property, given money to group who is “hard done by” – if you aren’t willing to do that, you are faking your belief in a distribution issue. 

  Indeed.
• Matt's sick of Gen X / Gen Y whinging about house prices and wanting transfers. 

I agree with Matt that most of the demand side schemes are horribly misguided. But current housing policy prevents substantial expansion of current supply, inducing large regulatory transfers to those who bought houses when supply was less constrained. In a world where supply could expand (both with increased density and expansion in the suburbs), we wouldn't get the kinds of price run-ups now being experienced in Auckland. Matt's right that more people, and especially young mobile people, should rent rather than buy.

What we really need to figure out are policies that pay off the losers while expanding supply. We have something of a transitional gains trap in housing policy. Current homeowners do get some direct benefits from regulations preventing both them and their neighbours from developing: NIMBY is NIMBY for a reason. But another large effect is that the NIMBY regs keep up house prices as a whole. Sufficiently expansionary housing policy would impose capital losses on homeowners. And we tend not to have easy ways of implementing those kinds of policy changes without compensating those adversely affected so that we can move towards the more efficient equilibrium.

And so I was really disappointed to hear Gerry Brownlee on the radio this morning. One thing that could help Auckland move toward expanding on the fringes would be allowing the use of congestion charging to both internalise the consequent externalities and to help defray the costs of any new roading necessary to service the new communities. It's the kind of policy that compensates the losers (at the margin) while taxing the winners (at the margin). Gerry Brownlee on Radio New Zealand this morning suggested that Auckland wouldn't be allowed to implement congestion charging. Gerry should remember that it's socialists, not free-marketers, that usually recommend that scarce resources be allocated by queuing rather than by prices. If Auckland's willing to move toward sensible road pricing, and they're blocked by central government, we're in rather a bad spot.

Housing Tradeoffs

The RBNZ is looking more seriously at loan-to-value ratio regulations to curb house price appreciation.

I've been skeptical about LVR regulations. If adopted as a "thou shalt not loan more than x% of the house's value" commandment applying to all new loans, they would have substantial effects on first home buyers unable to lean on family for support. If Matt Nolan is right that the banks really still have some implicit guarantee despite the OBR mechanism, there could be public interest in such regulations; a serious recession coupled with housing bubble collapse would then have banks taking a large hit while auctioning defaulted properties. But, any "making houses more affordable" justification for the regulations seemed exceptionally weak as the policy seemed likely to induce a level shift followed by a return to the prior price path. In other words, we'd be back on the same path of housing price appreciation after a one-off drop in prices concentrated among those homes favoured by first home buyers.

Fortunately, the RBNZ is not as silly as all that. They write:

we favour speed limits over outright restrictions. We do not want to ban high LVR lending; we would prefer to restrict it as a share of banks’ total new lending. With a speed limit approach, we expect banks would need to build in their own internal buffers to give themselves a margin of error. Such buffers could reduce as banks become better at controlling their proportion of high LVR lending. Within the speed limit, each bank would make their own assessment of which customers received high LVR loans, based on their own criteria including other risk measures, such as debt servicing capacity, and the potential long-term value of those customers to the bank.

Implemented this way, much of the beautifully written snark I had prepared now has to be deleted.* The equity effects still hold, but in attenuated form. When property prices start ramping up along with LVRs, first home buyers without family backing will get hit even more strongly than they are currently, but so long as the LVR proportion is set sensibly, it won't bind most of the time.

Further, RBNZ recognises all the workarounds that are likely to emerge. Parents will take out a mortgage on their paid-off homes to lend to the kids as starter capital; there's nothing the bank can or should do about it. A secondary loan market will emerge, but borrowers there will incur higher interest rates than they would in the mortgage market, so the system still works to discourage high LVR loans at the margin.

I'm still having a hard time seeing how the policy has anything but transitional effects on home affordability though. I would expect the regulation to result in a one-off drop in the price of starter homes, followed by a move back to the prior expected path of price increases. Effects on homes farther up the food chain will be rather substantially attenuated as the LVR is still less likely to bind for those with reasonable existing home equity to apply to a new home purchase with the sale of the old one; ability to service the mortgage out of existing income ought to bind before the LVR does for anybody with enough equity. NBR notes that John Key wants first-home buyers exempted from the rule; I have a hard time seeing that it would be binding on anybody under that scenario unless lots of folks are buying investment properties with no equity. If lots of investment properties are being bought on very high LVR loans, then I move from mildly meh to somewhat in favour of the regulation change.

Now here's the RBNZ:

While the Reserve Bank’s mandate is to promote financial stability, not social equity, there are clear implications here for housing affordability. As house prices and debt levels trend increasingly upwards, so too housing becomes less affordable, particularly for first home buyers. While macro-prudential policy measures might make credit less accessible for a period, they should help to make house prices more affordable in the longer term. Such measures should also reduce the risk of a sharp housing downturn and the loss of equity that would result, particularly for highly indebted home owners.

I agree with Nolan that the RBNZ doesn't have a housing affordability mandate. The best reason I can see for RBNZ's running this is as part of its prudential supervisory role looking over the banks so that they're less likely to take on too much housing risk in the expectation of being able to lay it off on taxpayers in case of a substantial downturn.** I have a much harder time seeing this as part of inflation policy: CPI is based on rent, not property prices, rents seem to lag prices, and I doubt that the policy has much effect on housing prices except among the homes purchased by first-home buyers, and even there only tapering off peaks as LVR spikes.

And it seems odd to highlight affordability for first-home buyers when the policy is most likely to make it rather harder for them to finance their first homes.

* The Game of Thrones analogy might have been overwrought anyway; you'll now never get to judge.

** Again, though, I think that the OBR mechanism does a lot to prevent that state of the world from obtaining.

The Christchurch Problem

Want a single picture illustrating the problem with Christchurch's rental market? Thanks to a hard-working boffin at MBIE, here's a nice one. 

I'd wondered whether the reported drop in the number of affordable rentals reported by MBIE was simply due to reduced availability across the board or whether it reflected a rightwards-shift in all rents. And so I asked for the graph below.*
Those renting a property in New Zealand lodge a bond with the Tenancy Tribunal. The graph comes from their data, via MBIE. We see a massive drop in the number of new tenancies at lower weekly rentals and about as many higher-rent tenancies as there were pre-quake.

The graph above shows the absolute drop in lower-rent tenancies. We can also graph things cumulatively to show the change in the proportion of total rents at each rental band.* The rightward shift in bonds paid is rather pronounced. But without data linking addresses to bonds paid, it's pretty hard to distinguish between a few potential stories. The graph cannot tell us whether we simply had destruction of low-end properties and no change in the rest of the market or across-the-board destruction and then shifts in the price of lower-end properties such that the number of tenancies in the $400-500 per week range remained roughly constant. It seems almost certain that both were going on, but we can't really say much without address-bond-linked data.

Also, the bond data only captures new bonds lodged. Some of the decline in new bonds posted could be due to tenants being reluctant to shift where rental availability is thin. Some of the drop in bonds could also reflect a shift of rental properties into the short-term holiday home market. On the other hand, many long-term tenants may have been displaced where either the house needs to be repaired or where the owner wishes to live in the house while the owner's home undergoes repair work. Either way, the new-bonds-posted data gives a reasonable reflection of the going price of current rentals in Christchurch. Or, rentals as of 2012.

In 2010, there were 18,094 bonds posted. In 2012, 14,695. That's a 19% drop despite rather a few homeowners needing to rent a property.

Thanks to MBIE for providing useful data and discussion!


* Some browsers have problems with the embedded Google Docs graphs. SciBlog's WordPress implementation also usually gets cranky about it. So here are static image versions for those needing them.

Tony's Plan

BNZ Chief Economist Tony Alexander has a few recommendations to fix the housing market. Let's take them in turn. My comments are the secondary bullets.

• Initiate a large builder training programme targeting not just youth but low skilled migrants. "Yes, the migrant gates would need to be opened. Just the signalling of strong intention to boost builder numbers would make investors think twice about their capital gain assumptions," he says.
  • Not a bad idea, but I'd expect expansion in builder training to come with increased demand for new construction; it could be that there are hold-ups in the training schemes with which I'm unfamiliar though. 
  • I would also note that there is a current massive demand pull for Christchurch. It will be difficult to build Auckland out & up at the same time as we rebuild Christchurch. 


• Ban councils from imposing any development fees and allow developers to install their own infrastructure.
  • A bit further than I'd have gone, but I'll take this over the status quo. We do need to learn from America's municipal utility districts.


• Create an SOE whose sole purpose is to undercut existing building materials suppliers through bulk purchases from offshore, nodal warehousing and distribution from just three or four locations in the country, with a separate agency responsible for monitoring the quality of materials sourced.
  
  • I can believe that we have substantial inefficiencies of scale in building supply. But there are so few barriers to anybody who wants to start shipping in container loads of building supplies from abroad, I'm a bit puzzled why we think that inefficiencies would persist once building started ramping up. On the other hand, we have seen substantial materials cost inflation in Christchurch. Count me as skeptical that this one passes cost-benefit. We'd need to pretty clearly state the market failure Tony thinks here is operating and why this is the best way of solving it. I'm reminded of my undergrad macro prof who thought it would be a good idea to have a government-run set of gas stations that used US reference point pricing.


• Initiate a new large state house building programme relying largely on the to be created new carpenters etc. Constrain new state houses to more efficient building systems including containerised modular housing (this doesn’t involve shipping containers), central and screwed in foundations, etc. Ban house sales to non-residents (even new houses given the ease with which special developments could arise targeting solely folk offshore and soaking up construction sector resources).
  
  • State housing is really a second-best kind of solution. Where the private sector is forbidden by Councils from expanding supply, I can see an argument for it. But otherwise, surely it makes better sense to allow more building and give poor people money. I'm reminded of the difficulties involved in Housing New Zealand's divesting itself of some $1m+ state houses in Auckland.


• Impose a tax on all houses owned by Kiwis offshore with the aim of encouraging them to sell them.
  
  • I'm rather sure that recent numbers have shown few houses are being purchased by people who have no intention of coming here. And recall too that there exists a rental market. For this to screw anything up, it has to be the case that supply constraints remain pretty binding AND that none of these overseas owners rent out the houses that they're not occupying.


• Put in place a capital gains tax on second properties and farmland and immediately payable stamp duty for all second house purchases.
  
  • Seamus has carefully provided the many reasons that CGT won't much help. And the Oz productivity commission just recommended the abolition of their stamp duty. Come on.


• Rezone all land within 10-20 kilometres of existing city boundaries as residential.
• I'm cool with this, so long as we're not then taxing owners of agricultural land as though Council had provided subdivision-density infrastructure to paddocks.

Update: Thinking more on the SOE plan, if Alexander thinks the thing would be profitable, surely the Bank of New Zealand could simply announce some business plan competition where BNZ would provide financing for the best business plan aimed at improving materials supply and distribution.

Christchurch Housing

I'd missed the Ministry of Business, Innovation and Employment's summary report on Christchurch housing when it came out a couple of months ago.*

The highlights:

• Total housing stock dropped by a net 11,500, or 6.2% of the ex ante housing stock, from 2010Q4 to 2012Q4.


• The number of private rentals as measured by tenancy bond remained constant at 39,000 during 2011 and 2012; the prior trend had increases of 1500 per year prior to 2010. 
  Demand for rentals would have increased sharply with destruction of owner-occupied homes, temporary moves by those getting repairs, and incoming construction workers. The largest drops were in tenancies of 2 to 3 bedroom homes.


• House prices in Christchurch are well above their prior 2007 peak, though Auckland's prices have ramped up by even more. But Christchurch rental prices have increased by more than Auckland. From August 2010 through February 2013, the average Christchurch weekly rent measured by new bonds lodged** increased by 31%, from $293 to $384. Auckland rental prices increased by 13% over the same period. 
• While average weekly rents remain higher in Auckland and in Wellington, the 2012 Household Income Survey has household income in Auckland at $94k, Wellington at $93k, and Canterbury at $82k.


• Rental accommodation at the bottom end of the market have been particularly hit. MBIE notes that MSD reckons $180/week about what beneficiaries can pay in rent; the proportion of private new bonds lodged in that range has halved since the quake. 
• I'm following up with MBIE for a bit more data on the overall distribution.


• Social housing units, whether provided privately as bedsits and boarding houses or publicly as Council housing or Housing NZ units, have also dropped substantially. Housing NZ was down 6% as of December 2012; I understand that the government pushed pretty hard to get the Housing NZ units sorted despite some thorny insurance issues. Christchurch Council is down 17%. The low-income tenants here served would not have an easy time finding alternative accommodation. They're being outbid for private rentals by incoming construction workers and by people seeking temporary accommodation during earthquake repairs. 
• I note that measures that could increase supply at the lower end of the market, like making it legal for private homeowners to build secondary flats into their homes, would result in fewer vulnerable tenants being displaced. 


• Holiday parks, which sometimes provide overflow temporary accommodation rather than just catering to tourists, are also overflowing. 
• I note that Council staff came close to shutting down the South Brighton holiday park when its toilet block failed an engineering code assessment; they backed down when it hit the press and instead are letting it be strengthened.  

The report also warns of a huge increase in accommodation demand set to come in 2014-2016 when an estimated 15,000-25,000 construction workers will be looking for housing at the same time as tens of thousands of home repairs create demand for short-term accommodation.

There's no way that allowing secondary flats within peoples' houses would come close to meeting the demand that's yet to come. But neither is there any reasonable reason to continue banning one of the easiest ways of getting quick temporary accommodation to market.

It will be interesting to see what will happen in 2014-2016.

* I'd linked the report here, but hadn't gone through it in depth.

 ** This will provide a better indicator of current market prices than would a measure of all existing rents: it shows what prices are faced by those coming to market.

Can tax and subsidy incidence really be negative?

Imagine a country where shoes cannot be imported and furthermore the elasticity of supply of shoes is very low. Imagine that the government in this country subsidises shoes. The person on the street who doesn't understand tax incidence might think that this policy lowers the price of shoes by the amount of the subsidy. An economist, however, would be likely to point out that, because supply is fairly unresponsive to price, the subsidy mostly results in an increase in the before-subsidy price to the seller.    In our jargon, he would be saying that most of the incidence of the subsidy would be on sellers and only a bit on buyers.

So far so good, but what if that economist now explained that removing the subsidy would make shoes cheaper to consumers, by stopping buyers from bidding up the price. This would seem to now be claiming that the incidence of the subsidy on buyers would be negative. Sure removing the subsidy would reduce the price to sellers but it would be a very strange model that would have the price falling by more than the reduced subsidy. In fact, it would seem to require that the supply curve be downward-sloping. 

And now, imagine that the economist further claimed that removing the subsidy would be good, as it would result in investors switching from investing in shoe production to investing in productive assets. This would go beyond strange. Sure the subsidy might have been diverting assets to having too much shoe production and not enough other stuff, but in what sense would we say that producing shoes is unproductive? And, how is it consistent to argue at the same time that removing the subsidy would lead to less investment in shoe production at the same time as arguing that it would result in lower shoe prices for consumers? 

O.K. this country, this policy, and this economist are fictitious. But if we change "country" to "New Zealand", "shoes" to "housing", "subsidy" to "tax exemption", and "economist" to "Gareth Morgan", you pretty much get this blog piece from Gareth on Tuesday. 

Gareth argues, correctly, that owner-occupied housing receives a favourable tax treatment relative to other investment since we are not charged income tax on the implicit rental payments we receive from ourselves. But he then goes on to argue that removing this exemption would "bring affordability within reach of many more families". This is an argument I have commented on before; it really looks like arguing that tax incidence can be negative: If housing is effectively subsidised by the tax system, we can't expect removing the subsidy to make it more affordable. 

And he then says that our tax treatment of housing has "discriminated against productive investment in favour of property speculation". Now if he means that we have invested too much in building houses and other kinds of investment, then we have to ask: In what sense is it unproductive to build houses that provide housing services to people that they value enough to pay for? And, how is it possible that curtailing such investment would "bring affordability within reach of many more families"? If, in contrast, he means diverting investment resources from building new equipment to buying existing houses as speculation, I have my perennial concern that this line or argument fails to note that buying existing houses for speculation or other reasons is not "investment" at all, and the assumptions you have to make to conclude that such behaviour diverts resources away from productive investment are a stretch to say the least.  

One final curious seeming contradiction in Gareth's post. At the start, he notes "When, not if, interest rates increase, this illusion that housing is `affordable' will burst....house prices will adjust". But later he suggests that if we don't remove the tax-favoured treatement of housing, he should "go out and buy another three houses now and just wait for the rest of you to bid the prices up". Why would that be good personal investment advice if, as he says, house prices are sure to fall? What am I missing?

Agreeing and disagreeing with Tim Hazledine

Auckland's Professor Tim Hazledine says New Zealand's real problem is low income, not the cost of living. While I agree that, longer term, we do have a productivity/income problem, we perhaps have different takes on solutions.

First, imagine that labour productivity doubled and that wages doubled. Some cost-of-living elements would ease substantially - food and tradeable goods in particular would become much cheaper relative to income. But what would happen to the cost of housing in Auckland or Christchurch? If housing supply is inelastic, then its price goes up with demand. Double incomes, and some of it will turn into improved housing quality via home improvements. But much of it will just bid up the cost of housing. How much of the wage increase would be eaten up in housing cost increases would depend on the income and price elasticities of housing demand and the price elasticity of housing supply - in other words, I don't know. But I don't think it's nuts to think you could eat up a reasonable part of any income increase with housing price increases given tight supply conditions.

Tim writes:

"I don't think it's a crisis and I don't think it's something we can do a lot about," he said.

"The main problem is on the income side and how much money we've got to spend."

He said the key to making things more affordable is to raise incomes and, in particular, to raise the minimum wage.

Hazledine says New Zealand is not a particularly productive country in economic terms.

"We don't have such high wages as Australians in particular do. This is why many New Zealanders move over there."

Incomes in New Zealand have kept in pace with inflation but have not got ahead of it.

Hazledine believes this is part of the issue. "We haven't really grown over the last 20 years and that's the problem."

If we have a low productivity problem, raising the minimum wage is not a particularly good idea. The minimum wage is $13 was $13.50 in 2012. The median hourly wages in the 2012 Income Survey was $20.86, so the minimum wage is 62 65% of the median wage. That's already really high by international standards; disemployment risks are pretty substantial. Stories getting to higher productivity from higher minimum wages tend to either be trivial (all the low productivity people are fired, so all we have left are the higher productivity ones. So yay! Productivity is up!), or, to me, implausible (some kind of efficiency wage story where no employer figures it out on his own; monopsonistic employers having aggregate effects on skill acquisition). If productivity is the problem, I'm really pretty sure higher minimum wages aren't the answer. And Tim forgets to mention that the Australian minimum wage for 16 year olds is half of the adult minimum wage, and that their minimum wages vary by industry.

I agree with Tim that the price of lots of things here seems very high. But I'm not sure that lack of competition is the most plausible answer. I can have books delivered to me from Book Depository in the UK for about 60% of the going NZ price; it's far more plausible that thin market problems and fixed costs in New Zealand are what inflate NZ book prices rather than lack of competition in the market for books.

But lack of competition is a more plausible explanation in other cases. RMA complaints kept IKEA from opening in Auckland and Wellington; furniture here consequently remains rather expensive and nobody will sell me horse-meat meatballs in lingenberry sauce. Westfield v North Shore City Council also showed how the RMA could be used to block competitors' entry.

On the whole, New Zealand runs a pretty decent set of policies for encouraging real competition: very low tariff rates while allowing parallel importation.

Both wages and real household income are up substantially on 1998.* The blue line below tracks median hourly real wages in 2012 dollars; they're up 14.6% from 1998 to 2012.** Hourly wages have continued upwards fairly nicely. Median real household income, the red line, is up 24.9% over the entire period but dropped with the recession and hasn't really come back.*** I'd expect that digging further into the tables would show some of that being due to labour force exit.

I worry that if the agglomeration folks are right, distance and scale will keep hurting New Zealand's relative position. Hiking the minimum wage really isn't much of a solution to this kind of problem. Instead we need to fix land use policy so we can increase population without killing housing costs and keep working to make New Zealand an attractive place for international migrants.

* Alas, NZDotStat only has Income Survey data back to 1998.

** Recall that the GST increased from 12.5% to 15% while income tax rates dropped to offset the increase in the GST. If you're using before-tax incomes, you have to use a GST-adjusted CPI.

*** Note that I've just used Google's default scaling for the graphs; using a zero bottom end would artificially suppress variance.

Valuing amenities

A few things I tell my Economics & Current Policy Issues Class:

• It's double-counting to weigh the direct costs of some disamenity as well as the disamenity's effects on land values because the latter incorporates the former (and the same for positive amenity affects);
• We can weigh the value of hard to value things like mortality risk by looking for effects on priced markets. Differential on-the-job accident risk can give us measures of the value of a statistical life. The value of a neighbourhood park can be approximated by housing price effects, and the same for the value of neighbourhood disamenities.

And so I'll have to remember this rather nice NBER working paper by Currie, Davis, Greenstone, and Walker. They pick a relatively hard case: plants that emit toxic chemicals that are sometimes hard to smell or see. They find emissions decline exponentially with distance from the plant, reaching baseline levels a mile from the plant. When a plant opens, housing prices in a half mile radius drop by 1-2%; when it closes, they go up by 2-3%. Within a mile, the price drop is 1.5%. A plant within a mile also increases the likelihood of having a low birthweight child by two percent (that percent, not percentage points, and the base rate incidence is low). 

When they add everything up, they find that a plant's opening reduces average housing market capitalisation in the surrounding mile by $1.5 million on average,* and that the costs of low-birthweight births in the surrounding mile are about $700k. So the disamenity cost, as measured by housing prices, is about twice the biggest likely measurable health effect. And that's entirely consistent with housing markets capitalising the real imposed disamenities. The biggest price effects are closest to the plant, where health disamenities combine with the noise and sight of the plant, then decline towards the one mile mark, where there are still real health effects but the other disamenities are negligible relative to those in the reference category of homes 1-2 miles away. 

They also find that neighbourhoods around plants pick up in demographic characteristics after a plant's opening: people move there for jobs. They wonder whether this is consistent with fully informed decision-making, but it's rather plausible that, given the low absolute risk imposed, households simply value being within walking distance of work more than they dislike the disamenties. 

On the whole I take this as pretty supportive of our base-line theory on this stuff and reasonable evidence against the "Oh, but people are stupid and irrational and they would never live there if they only knew and we have to ban a pile of stuff" alternative hypothesis.

* By way of comparison, they note that a typical plant - a small coal-power plant - costs $280m to build. The disamenity effect, though real, isn't some big huge cost that would tip the balance against approving the plant were it incorporated.

Consent constraint

From the Christchurch Press.

Item the first: there's a boom in building consent applications.

With the rebuild ramping up, the Christchurch City Council is struggling to find enough qualified people to process the hundreds of building consent applications it receives each month.

Building activity in the city has jumped markedly in the past four months, with the number of consent applications now at levels unseen since the peak of the 2007 building boom.

Many applications then were for minor building work that is now exempt from building consent requirements.

The council is dealing with a similar volume of applications, but the work is complex residential earthquake repairs and rebuilds.

Wow, they're busy. Ok. Item the second:

Of the 281 new homes approved in November [for the Canterbury region as a whole], 96 were in Christchurch and 185 in other Canterbury districts, figures show.

So Christchurch Council in December 2012 approved the construction of ninety-six new houses. 96.*

The Canterbury region as a whole had 4037 new dwelling consents approved in 2012.

If you go to the StatsNZ underlying data, you'll find Christchurch City approved 1,506 new dwellings in 2012.

Auckland as a whole had 4,581 new dwelling approvals. Auckland has a lot more people than Christchurch: roughly four times as many. And they only had three times as many new dwelling consents as Christchurch did.

So Christchurch Council approved a few more new dwellings than Auckland did, relative to population.

But more than 6000 homes in Christchurch were set for demolition because they sat in the Red Zone. And there are non-red-zoned houses that have to be demolished.

Some low income families in Christchurch live in tents and garages.

None of the low-income cohort that feature in the all-too-frequent Press exposes of Christchurch housing problems would ever be able to afford any of the stuff now being built, nor could they even if consenting were eased such that land prices could drop. They benefit instead when richer people move into new houses,  freeing up space in existing housing stock.

If approving new dwellings is too complicated and hard, Council could ease its burden by making it legal for owners of existing dwellings to build a rental flat into the existing house. A couple interior walls, a kitchen, and a bit of plumbing - pretty simple. Shame it's banned.** And, again, even if the people currently living in tents and garages couldn't afford those new units, they might be able to afford the places vacated by those moving into the new units. Or the places vacated by those moving into the places vacated by those moving into the new units.

Sometimes, allowing that more steps be built at the top or the middle of the ladder isn't a bad way of letting the folks at the bottom climb up a rung.

* In January, Christchurch Council also closed 31 social housing units because they no longer met earthquake spec.

** And see here.

Housing, with a bit of English

Deputy Prime Minister and Finance Minister Hon. Bill English weighs in on New Zealand's housing affordability problem in the latest edition of Demographia's international housing affordability survey.

He writes:

In its response to the Productivity Commission, the Government agreed with the Commission’s analysis that supply side factors explain the deterioration in New Zealand’s housing affordability. The Government’s response to the Commission’s report concentrated on land supply, infrastructure provision, costs and delays due to regulatory processes, and improving construction sector productivity.

Housing affordability is complex in the detail – governments intervene in many ways – but is conceptually simple. It costs too much and takes too long to build a house in New Zealand. Land has been made artificially scarce by regulation that locks up land for development. This regulation has made land supply unresponsive to demand. When demand shocks occur, as they did in the mid-2000s in New Zealand and around the world, much of that shock translates to higher prices rather than more houses. It simply takes too long to make new land available for development.

We may be seeing the beginning of a repeat of the mid-2000s demand shock. As interest rates stay below historic norms, expectations are shifting that these rates are here to stay. As a result, demand for real assets has increased, observed in booming equities markets in 2012. Demand for real estate is also increasing, with the median house price in Auckland recently exceeding the highs of 2007.

Costs of other housing inputs contribute to New Zealand’s affordability problem. Building materials cost more in New Zealand than neighbouring Australia. The structure of infrastructure financing, and the timing levies are to be paid, raises the market price for housing. Appeals under the Resource Management Act, New Zealand’s land use regulation, can hold up developments and city planning for a decade or more in some cases. Time is money because development is risky.
...

From the Government’s perspective, worsening housing affordability creates a number of problems. Fiscal pressures increase because financial assistance for housing is tied to its market price. Home ownership provides financial security and a form of savings and lowers dependence on public assistance later in life. Worsening affordability increases demands for direct intervention through rent controls and public housing. We are aware of the results of these sorts of interventions overseas and must avoid them.

New Zealand is not alone in its housing affordability problem and there seems to be increasing awareness around the world that the planning pendulum may have swung too far. Land use regulations and intrusive development rules have consequences.

The first step is admitting we have a problem. And I expect that English has a rather good idea of the things that need to be done. But many of them are outside his portfolio, and more of them wouldn't make Councils happy.

It is especially heartening to see English providing this statement as foreward to Hugh Pavletich's survey. Hugh has been the country's most tireless campaigner for fixing the regulatory mess that keeps housing prices up; he's also been a strong and public critic of Christchurch Council rules that have stultified post-earthquake development. This year's report puts Christchurch as worse than Los Angeles, San Diego, and Adelaide but better than Abbotsford, BC or the London ex-urbs.

File this under "Good Omens".

Manufacturing weakness

The RBNZ's Gael Price chalks up a fair bit of weakness in New Zealand's manufacturing sector to problems in the domestic construction industry. She writes:

An important factor behind this broad-based weakness in manufacturing was weakness in the domestic construction sector. Construction activity contracted by 22 percent between the December quarter 2007 and the December quarter 2009, and remained low in the following years. As we saw in figure 10, construction is highly dependent upon manufactured inputs. The fall in construction activity represented a significant decline in demand for the manufacturing industry. The elasticity shown in figure 10 implies that the construction industry contraction that took place between December 2007 and June 2012 is consistent, by itself, with a cumulative 8.5 percent fall in manufacturing activity – quite close to the fall that actually occurred (figure 16). Construction activity has remained very weak following the recession in various other advanced economies, and this weakness is reflected in the manufacturing output of those countries too (the United Kingdom is an example).

It would be one thing if the recession had dampened demand for residential construction; it then would be desirable to shift resources out of manufacturing for that sector and into other areas. But that really doesn't seem to be the problem - New Zealand property indices have housing above 2007 peak prices in Auckland and Christchurch; demand seems robust. Rather, Councils have effectively made it illegal to build new houses.

It's also mildly amusing that some of the same folks who shout loudest about declining manufacturing are also the folks who most strongly support heavy restrictions on residential construction. The two things are kinda linked.

More on Housing Affordability: Supply versus Demand

Over at TVHE, Matt has followed up on my post here on Gareth Morgan versus the Productivity Commission, arguing that we shouldn't view supply and demand explanations as mutually exclusive. Now I think Matt and I are pretty much in total agreement, but slight differences in language might make our posts seem at cross purposes, so I thought a couple of clarifications are in order.

First, the interesting question is not whether the cause of house-price inflation in New Zealand is supply, demand, or some combination of both. Obviously, since house prices are set by mutual agreement between buyers and sellers, prices are always and everywhere the result of both supply and demand. Rather the issue is, to the extent that house prices are inappropriate for some reason, whether the source of the inappropriateness is acting through supply or demand. Matt frames this by asking whether something is pushing demand for housing beyond what is "socially optimal" (or, by extension, restricting supply below what is socially optimal). Another way of saying this is to ask whether the policy response to high house prices would work by increasing supply (say changes to zoning or consent processes) or demand (say, changes in the tax treatment of housing).

The second clarification is that saying that supply and demand are not mutually exclusive is more than just saying that influences on both sides can contribute to the final effect. In the case of tax policies, the purpoted cause of house-price inflation only makes sense if there is an underlying problem with supply. To illustrate, consider Matt's statement

The key point against supply side issues will be fact that rental growth hasn't gotten as scary at any point -- if there are "too few" houses, then we should really see the cost of housing services/rent pick up.

The idea here is that if house prices are going up faster than rent, then the opportunity cost of owning a rental property must be rising faster than the direct income derived from it, so the only motivation must be the expectation of capital gain. This is true, but the expectation of capital gain only makes sense if the underlying trend is for the demand for housing for non-investment purposes to grow faster than supply. That is, to explain house inflation today as driven by tax-favoured investment, we need to assume a problem with restrictions on supply in the future.

Furthermore, consider what we would observe if there were no favourable tax treatment for owner-occupied housing or income derived from capital gains, but still an expectation of demand growth outstripping supply growth in the future. As long as the capital gains tax rate were not set at 100%, it would still be the case that expectations of future house price inflation would drive inflation in house prices today, there would be a positive after-tax return from capital gains, and hence a slower rise in rents, exactly the observations that Matt suggests might imply the problem is not exclusively on the supply side.

The bottom line here is that the favourable-tax-treatment story simply implies that problems due to insufficient supply will bite a bit earlier than they otherwise would have done. If there is no problem with supply being unable to keep pace with underlying demand, the tax-treatment issue is irrelevant.

Gareth Morgan on Housing Affordability

Gareth Morgan takes aim here at the Productivity Commission, for emphasising land supply as the major determinant of the high cost of housing in New Zealand. He notes that

[t]here are cities in the world with five times Auckland's population, living in an area no larger than Auckland's, and with housing prices lower as a percentage of income than in New Zealand.

Gareth, in contrast, points the finger at the Reserve Bank for directing banks to emphasise mortgage lending (for prudential reasons), and the tax code for favouring housing. He says that as a result of this "toxic duo" we have

driven the price of housing from twice the average household income to six times.

He restates his call for a capital tax (not a capital gains tax) to remove a distortion in favour of housing. Now, as I wrote here, I think that a capital tax has some really horrible properties that would swamp any benefits, but this is secondary to why I don't agree with this analysis of the NZ housing market.

First, explanations don't have to be either-or. Even if we agree that there are problems in New Zealand capital markets that contribute to house inflation, surely it would be the case that those problems are going to be more acute the lower is the elasticity of supply of land for housing?

Second, one of Gareth's concerns about the tax advantage given to housing is that it encourages people to buy housing as a path to prosperity, which presumably means that it is based on expected capital gain. Now this either means that house prices have been pushed up by a bubble, which will eventually burst without any change in the tax system, or that the fundamental price of housing is rising, and speculation is just bringing those price increases forward. If that is the case, then removing any favourable tax treatment on the capital gains from home ownership might cause a one-time drop in house prices now, but a faster increase in those prices in the future.

Third, Gareth's other concern about the favourable tax treatment given to housing--and the one that motivates Gareth's call for a capital tax--is the familiar fact that the implicit income earned from selling housing services to oneself in owner-occupied housing is not subject to income tax (although the transaction is implicitly subject to GST). This distortion will indeed cause the demand for housing to be higher than it otherwise would have been. But it will not cause the after-tax price of housing services to be higher, so again, it is hard to see how removing the tax distortion would be a solution to the problem the Productivity Commission are addressing.

Finally, if looking to the tax code to explain the change in house prices over time, or differences between countries in the fraction of income devoted to housing, one needs to identify time-series or cross-section differences in the tax code. Pretty much all countries have a tax code that favours owner-occupied housing and always have done. If anything, we have moved the tax code away from favouring housing in recent years with changes in the treatment of investment properties, and a switch from income tax to a higher rate of GST. And we don't have policies like the mortgage interest rate deduction that are seen in other countries, particularly the U.S.

Ultimately, it just comes down to ECON 100 supply and demand. The New Zealand population has been rising, and land-use policies have been preventing supply from keeping up with demand. Maybe those policies are a good thing, and we should be moving away from urban sprawl to high-density living. But it is hard to counter that the cost of such policies will be a steady increase in the price per square metre of housing.

More on Exchange Rates

Eric posted on Monday about the Stuff.co.nz article in which he was extensively quoted. I am mostly in agreement, with the article and Eric’s quoted comments, but there are a couple of places where I take issue.


First, the article takes as a given that the New Zealand dollar is overvalued. Now, this mantra is so commonly stated that one can hardly criticise a journalist for taking it as a received fact. Indeed, the article is able to reference a fairly high authority on this:

And the International Monetary Fund says the kiwi is about 15 per cent overvalued. It has said that repeatedly, at least as far back as May 2010.

Now staffers at the IMF are not stupid, and there is probably a well-defined question to which “overvalued by 15%” is the answer, but assessing that answer would require knowledge of what the underlying question is. The first thing I tell my 2nd-year micro students each year, that to start a piece of economic analysis with a price is to abdicate one’s responsibility as an economist. It is akin to a psychologist explaining some strange observed piece of human behaviour by saying “that is what they wanted to do”.

Let’s revisit some exchange rate basics. We have a clean floating currency. That means that the price of the currency is set at whatever level enables all who want to buy and all who want to sell at that price to do so. At first pass, that sounds like a perfectly valued exchange rate. Furthermore, the complaints about the kiwi being “overvalued” have been consistently heard for about a decade at least, so it would be hard to say that it is the result of a speculative bubble with speculators consistently entering on the demand but not the supply side.

So why is the dollar at the level that it is? One possible reason in recent years is the high demand for milk solids from China creating a boom for New Zealand dairy exports. Yes, this is not so good for manufacturing exporters, but the technical term for such a change is “the terms of trade going in our favour”. Alternatively, we can point to investment opportunities in New Zealand consistently being higher than the available pool of saving, coupled with a large pool of savings from China being available to prevent interest rates rising to choke off that investment. Again, a big increase in supply of foreign capital when NZ is a net buyer counts as a favourable terms of trade shock.

Pretty much the only way I can make sense of the “NZ dollar is overvalued” mantra is as an extension of the argument that New Zealanders are not saving enough, in the same sense that we don’t eat enough fruit and vegetables, drink too much alcohol, don’t attend enough classical music concerts, and have too much sex during rugby world cups.

But, and this is my second issue with the original article,  Eric is coming perilously close to this view when he is quoted as saying,

Fundamentally, New Zealand has a high exchange rate because we're an attractive place for foreign investors to put their money....Our relative lack of domestic savings in things other than housing means that the returns on other kinds of investment here are relatively high.

Hmmm. The fundamental problem with housing in New Zealand is land-use regulations reducing the extent to which savings can be directed into the creation of new housing stock. As I have noted before, the purchasing of existing houses is neither investment nor saving in aggregate, and so cannot explain the net demand for foreign capital.