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Debt­Watch No. 44 April 2010

House Prices Are Not Nor­mal

“I think it is a mis­take to assume that a risk­less, easy, guar­an­teed way to pros­per­i­ty is to be lever­aged into prop­er­ty. It isn’t going to be that easy.” (RBA Gov­er­nor Glenn Stevens, Sun­rise Pro­gram March 29 2010)

I applaud Glenn Stevens for mak­ing the above state­ment on nation­al tele­vi­sion. It was both coura­geous, and a suc­cinct and accu­rate state­ment of the delu­sion that has come to dom­i­nate eco­nom­ic think­ing in Aus­tralia. He effec­tive­ly acknowl­edged that Aus­tralia has suc­cumbed to a Ponzi Scheme: the belief that the entire coun­try can make a liv­ing from unearned income. This some­thing that, until recent­ly, most pub­lic and pri­vate com­men­ta­tors have been stren­u­ous­ly deny­ing. The great pity is that this real­i­sa­tion was so long in com­ing, while the farce is that one wing of Aus­trali­a’s gov­ern­ment has now declared its inten­tion to bring down a Ponzi Scheme that the oth­er wing is try­ing to main­tain.

The data that led Stevens to this real­i­sa­tion is pret­ty obvi­ous: the most recent quar­ter saw the largest increase in house prices since the ABS began keep­ing records in 1986.

The role of the Fed­er­al Gov­ern­ment in caus­ing this bubble–and ear­li­er ones–via the First Home Own­ers Grant is also obvi­ous. While pre­vi­ous manip­u­la­tions of the mar­ket by the Grant turned a tepid rate of increase into a bub­ble, this time the Grant turned the fastest rate of fall in house prices into its great­est rate of increase. The cur­rent volatil­i­ty of house prices is telling: eight of the ten biggest movements–in both directions–have occurred in the last two years.

With the RBA like­ly to increase rates specif­i­cal­ly to prick this bub­ble, the volatil­i­ty will doubt­less con­tin­ue. But even with­out the RBA’s expected–and I have to say justified–anti-bubble inter­est rate inter­ven­tion, the real estate mar­ket is, as Stevens argued, far from a sta­ble route to rich­es.

House Prices are Not Normal

One of the great fal­lac­i­es of con­ven­tion­al “neo­clas­si­cal” eco­nom­ics that encour­aged behav­iour that caused the GFC was the propo­si­tion that asset prices are “Normal”–in the sense that their volatil­i­ty fits the pat­tern described by the “Nor­mal Dis­tri­b­u­tion”.

The super­fi­cial beau­ty of the Nor­mal Dis­tri­b­u­tion is that the behav­iour of a vari­able can be reduced to just two numbers–its mean and stan­dard devi­a­tion. But its real, deep beau­ty is that if a vari­able fol­lows a Nor­mal Dis­tri­b­u­tion, then extreme events are van­ish­ing­ly rare. if a vari­able moves nor­mal­ly, then:

• Move­ments of 5 stan­dard devi­a­tions or more above or below the mean are so rare as to be effec­tive­ly non-exis­tent; and
• Their rar­i­ty means that they play no sig­nif­i­cant role in shap­ing the sys­tem: its behav­iour is com­plete­ly described by the events that fall with­in the +/- 5 stan­dard devi­a­tions range.

As stock mar­ket spec­u­la­tors learnt to their great cost dur­ing the GFC, that is so not the case for share prices–since “impos­si­ble” or “Black Swan” move­ments in prices have been the order of the day since 2007.

For exam­ple, the aver­age dai­ly move­ment on the Dow Jones since 1914 is 0.028%, while the stan­dard devi­a­tion is 1.13%. If stock mar­ket price move­ments were “Nor­mal”, there would have been just one dai­ly decline of more than 4.5 per­cent since 1914. In fact, there were 100 such falls, out of a total of 24,593 dai­ly move­ments in the Index–fully 100 times as many falls as a Nor­mal dis­tri­b­u­tion would pre­dict.

Nor could those falls be ignored in the long run: they caused a col­lec­tive 612.5 per­cent fall in the Index, when the sum of all the per­cent­age move­ments since 1914 is 688 per­cent.

Any­one who relies upon the Nor­mal Dis­tri­b­u­tion when invest­ing in the stock mar­ket is ulti­mate­ly on a hid­ing to noth­ing to lose his shirt, because the Nor­mal Dis­tri­b­u­tion seri­ous­ly under­es­ti­mates the odds and the impor­tance of extreme volatil­i­ty in share prices. A far bet­ter guide to how share prices actu­al­ly behave is the “Pow­er Law”, as well as Didi­er Sor­net­te’s research based on an anal­o­gy to earth­quakes.

So how do house prices stack up? Though we have a far short­er time series for house prices than for shares, one thing is for cer­tain: house prices are not Nor­mal. The mean quar­ter­ly change in the ABS series for nom­i­nal house prices since 1986 is 1.24%, and the stan­dard devi­a­tion is 1.786%. If house prices were Nor­mal, the dis­tri­b­u­tion of quar­ter­ly changes would look like the red line in the next chart; the actu­al pat­tern is shown by the blue bars.

The vast major­i­ty of quar­ter­ly move­ments are below the mean, with the largest number–27 out of the 93 quarters–registering just above zero change (an aver­age of 0.267% increase for the quar­ter). The high over­all aver­age of 1.24% growth per quar­ter in nom­i­nal house prices is dri­ven by the small­er num­ber of quar­ters (26 out of the 93) with increas­es above the aver­age.

The data is skewed in time as well as mag­ni­tude. A tru­ly Nor­mal dis­tri­b­u­tion would have no time pat­tern to the data, with a large move­ment just as like­ly to be fol­lowed by a small one. The actu­al dis­tri­b­u­tion has long peri­ods of low increas­es with clus­ters of large changes–and these have increas­ing­ly involved large falls as time has gone on. The next chart com­pares the actu­al pat­tern of price move­ments (in red) to a sim­u­lat­ed ran­dom pat­tern (the black cross­es).

There are sev­er­al movements–especially the ‑3.4% and +7% record­ed since the GFC began–which are out­side the stan­dard range for a Nor­mal Dis­tri­b­u­tion. They are not so far out­side that we can cat­e­gor­i­cal­ly say that a Pow­er Law accu­rate­ly describes house price move­ments, as we can with share prices. But the odds are that these two lever­aged asset class­es share the same fun­da­men­tal dynam­ics.

The FHOG of Real Estate

It should also come as no sur­prise that the First Home Own­ers Grant scheme sig­nif­i­cant­ly dis­torts the hous­ing mar­ket. From the sta­tis­tics, there is no doubt that the true ben­e­fi­cia­ries of the scheme are ven­dors, real estate agents, and lenders–not first home buy­ers.

There are sev­er­al ways to slice and dice the data on this point: there are years when there was no Grant, and years when there was a grant in some form or anoth­er; peri­ods pri­or to the intro­duc­tion of a Grant, or a change in its mag­ni­tude, and peri­ods after the change; and peri­ods when the Grant was dou­bled. The fol­low­ing charts show these dis­sec­tions.

Peri­ods with­out a FHOG had sig­nif­i­cant­ly low­er growth in house prices, and sig­nif­i­cant­ly low­er volatil­i­ty in prices. The aver­age quar­ter­ly price change with­out a FHOG was a mere 0.44%–one third of the aver­age for the entire series. The volatil­i­ty was also sub­stan­tial­ly low­er, with all move­ments being between ‑1 and +2.5%.

Peri­ods with a FHOG had both sub­stan­tial­ly high­er aver­age price ris­es (2% p.a. vs 1.25% for the entire set) and sub­stan­tial­ly greater volatil­i­ty (rang­ing from ‑3.4% to + 7%).

A clos­er look at the impact of the FHOG shows that its role is that of a storm troop­er for the hous­ing mar­ket. The next chart looks at the move­ments in house prices in the 2 years after an intro­duc­tion or change to the Scheme, and in par­tic­u­lar at what hap­pens to prices in the 2 years after the pay­ment was dou­bled (in 2001 under Howard and 2008 under Rudd). The “Pre-FHOG” is all oth­er quar­ters apart from these 2 year seg­ments.

All but one of the large increas­es in house prices (4% or more in a quar­ter) occurred after the FHOG was dou­bled, while the aver­age quar­ter­ly change in prices was over 2.9 per­cent. If the FHOG is the real estate sec­tor’s storm troop­er, then dou­bling the FHOG is its Panz­er divi­sion.

The next table sum­maris­es the sta­tis­ti­cal prop­er­ties of house price changes, includ­ing “Kurtosis”–a mea­sure of how peaked the dis­tri­b­u­tion is com­pared to the Nor­mal Distribution–and “Skew”–a mea­sure of how biased the dis­tri­b­u­tion is towards above or below mean move­ments. Peri­ods with­out a FHOG have a peaked dis­tri­b­u­tion (Kur­to­sis greater than zero) and few price changes below this peak with many above (Skew greater than zero); peri­ods with a FHOG have a flat­tened dis­tri­b­u­tion (Kur­to­sis below zero, mean­ing that price move­ments are more wide­ly dis­persed), and a neg­a­tive skew (mean­ing that there are more price move­ments below the mean than above).

The role of the FHOG in caus­ing house prices to rise faster than con­sumer prices is even more appar­ent if we con­sid­er the annu­al CPI-deflat­ed series–but what is then also obvi­ous is its decreas­ing effec­tive­ness over time. When rolling annu­al price changes are considered–a more real­is­tic time frame for changes in house prices, since this is a slow mov­ing asset market–the biggest price infla­tion bang for the FHOG buck was back in 1988, when the rate of increase hit almost 30%. Howard’s dou­bling could only score a 16.5% max­i­mum rate of growth of real house prices; Rud­d’s has thus far peaked at 11.25%–though this omits the impact of the most recent 7% increase in nom­i­nal house prices (since CPI num­bers are only avail­able till Decem­ber 2010).

The real house price data empha­sis­es the mes­sage that the real ben­e­fi­cia­ries of this gov­ern­ment inter­ven­tion are not first home buy­ers, but ven­dors, real estate agents, and banks–in increas­ing order of ben­e­fit.

The ven­dors ben­e­fit from a high­er price; the agents ben­e­fit from high­er turnover and fees; while the banks ben­e­fit from the increased mort­gage debt that first home buyers–and then the ven­dors they sell to–take on in order to buy into a gov­ern­ment-sup­port­ed Ponzi Scheme. The banks and mort­gage lenders in gen­er­al have been the biggest ben­e­fi­cia­ries as mort­gage debt has risen from under 20% of GDP in 1990 to over 85% at the end of 2009.

The revival of this Ponzi Scheme played a key role in Aus­trali­a’s side­step of the GFC. As is obvi­ous in the next chart, the mort­gage debt to GDP ratio began to fall pri­or to the First Home Ven­dors Boost, but then accel­er­at­ed once the Boost was avail­able.

The Aus­tralian econ­o­my has thus returned to debt-dri­ven growth, with the house­hold sec­tor car­ry­ing the full bur­den for the pri­vate sec­tor. I remain scep­ti­cal this peri­od of debt-dri­ven growth will last as long as in pre­vi­ous bub­bles when our pri­vate debt to GDP ratio was half what it is today.

Table One

Table Two

End of Debtwatch Report

I start­ed Debt­watch to raise the alarm about the approach­ing finan­cial cri­sis that we now call the GFC, and to raise aware­ness of the uncon­ven­tion­al eco­nom­ic the­o­ries of Hyman Min­sky. Forty four Debt­watch Reports lat­er, those objec­tives have been met, and main­tain­ing the pace of one major report each month is now ham­per­ing my abil­i­ty to write a book length treat­ment of the Finan­cial Insta­bil­i­ty Hypoth­e­sis.

I signed a con­tract for this book with Edward Elgar Pub­lish­ers back in 1999, with the inten­tion of deliv­er­ing it in 2001. Then I decid­ed to write Debunk­ing Eco­nom­ics, which I thought would take just six months. 18 months lat­er, I fin­ished it, and the debate it caused with neo­clas­si­cal econ­o­mists (due to my nov­el cri­tique of the the­o­ry of com­pet­i­tive mar­kets) took up anoth­er 4 years.

I planned to start Finance and Eco­nom­ic Break­down in Jan­u­ary 2006—and in Decem­ber 2005 rais­ing the alarm about the GFC took over.

Now I real­ly have to give the book first pri­or­i­ty. With each Debt­watch Report tak­ing some­thing close to a week to write, I can’t do both. So I am going to cease pub­lish­ing Debt­watch.

What I will tri­al instead is pub­lish­ing a month­ly update on the book. I will no longer send this out as a PDF, but will make it my month­ly blog entry.