Is it all “Supply & Demand”?

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As we head towards the fed­er­al elec­tion, the term ‘hous­ing short­age’ will be trot­ted out again and again by politi­cians. Their rhetoric will rely on the deeply ingrained received wis­dom that Aus­tralia has a ‘hous­ing short­age’, and no politi­cian will want to do the hard work of dif­fer­en­ti­at­ing between a gen­uine short­age in hous­ing stock (which we don’t have) and a short­age of ‘afford­able hous­ing’ which we do have.

And why won’t they acknowl­edge this dis­tinc­tion? Sim­ply, because admit­ting that it is only the prices of hous­es that are dys­func­tion­al, and not sim­ply the sup­ply, would be too much even for their loy­al vot­ers.

Once group­think has infect­ed politi­cians and media com­men­ta­tors, rea­son goes out the door. That’s why I find it infu­ri­at­ing to hear con­stant ref­er­ence to Aus­trali­a’s soar­ing prices being sim­ply a prod­uct of a ‘sup­ply and demand’ imbal­ance.

The sup­ply-demand argu­ment is easy to sell. The rea­son­ing goes that there are too few hous­es being built, and the hous­ing mar­ket is just like any ordi­nary com­mod­i­ty mar­ket, so the price ris­es.

This pric­ing mod­el is super­fi­cial­ly appeal­ing at the lev­el of every­day con­sumer items – cork­flakes, for instance (though even here it’s a flawed log­ic, as I explain in these two [1] [2] rather tech­ni­cal papers). But the mod­el breaks down com­plete­ly in asset mar­kets. If the price of cork­flakes ris­es due to sup­ply con­straints, con­sumers switch to com­ple­men­tary goods. They don’t rush to the super­mar­ket to buy more corn­flakes at the high­er price.

But in asset mar­kets, con­sumer behav­iour is turned on its head. Instead of being more reluc­tant to buy an asset that is ris­ing in price, buy­ers rea­son that they’d bet­ter get in quick and buy while the asset is still with­in their reach. So high­er prices actu­al­ly stim­u­late demand, and this behav­ior often reach­es a fever pitch a short time before an asset bub­ble deflates.

In oth­er words, prices have a per­verse impact upon asset mar­kets, and it is sim­plis­tic to inter­pret how asset prices behave sim­ply on the basis of “sup­ply and demand” analy­sis.

It’s also rather hard to sus­tain the “sup­ply and demand” argu­ment on the basis of the data alone—because it if were true, house prices should have been falling (rel­a­tive to the price of oth­er goods) for most of the last thir­ty years.

First­ly it’s obvi­ous that real house prices have been ris­ing in real terms. The next chart deflates the ABS’s index for estab­lished hous­es (ABS 641601 and 641603) by the CPI. Hous­es are now two and a half times as expensive—relative to oth­er goods—as they were in 1986.

And yet for most of that peri­od, we’ve been build­ing accom­mo­da­tion at a faster rate than pop­u­la­tion has been growing—so on “sup­ply and demand” log­ic, house prices should have been falling for all but the last cou­ple of years.

Have a look at the chart below. The aver­age num­ber of peo­ple liv­ing in each dwelling in Aus­tralia in the year 2007 was around 2.6 (the black line)—and it was high­er in ear­li­er years. To keep the ratio of peo­ple to dwellings con­stant, we would need to build a new dwelling for every 2.6 new peo­ple. In fact, on aver­age between 1986 and 2009, we’ve been build­ing a new dwelling for every 1.8 new Aus­tralian res­i­dents. Only in the last cou­ple of years—after the GFC hit—has pop­u­la­tion grown more rapid­ly than we’ve added accom­mo­da­tion.

This is where neo-clas­si­cal econ­o­mists’ ‘sup­ply-demand’ argu­ments fail the com­mon-sense test. If we’ve con­sis­tent­ly built more new dwellings than required by the num­ber of new peo­ple in Aus­tralia, and if “sup­ply and demand” explained every­thing, then real prices should have been falling for all but the last cou­ple of years (in the past two years a new dwelling has been built for approx­i­mate­ly every 3 new peo­ple – see chart).

News last week that Syd­ney has just record­ed a six-year high in build­ing approvals (http://www.smh.com.au/business/property/big-surge-in-number-of-new-homes-approved-20100505-uas8.html) will be wel­comed by politi­cians and com­men­ta­tors want­i­ng to argue that the ‘short­age’ is being addressed.

But if ‘sup­ply and demand’ can­not explain the rise in house prices over the past quar­ter cen­tu­ry, then this addi­tion­al supply—when it comes online—may have an equal­ly per­verse impact: it might accel­er­ate a down­turn caused by the end of the great expan­sion in house­hold debt that has been the real force dri­ving house prices up. The new spike in approvals may actu­al­ly cre­ate an over­sup­ply after the great infla­tion caused by ris­ing debt has already end­ed.

We need to bury the ‘hous­ing short­age’ myth, but to do so requires a shift in think­ing. Econ­o­mists fol­low a mod­el of the econ­o­my that is as real­is­tic as the view that the Earth is the cen­tre of the uni­verse, and the Sun, Moon and plan­ets revolve around it. It took the GFC to expose just how unre­al­is­tic this mod­el is—a mod­el that ignores cred­it and pre­tends that every­thing hap­pens in equi­lib­ri­um. We instead live in a cred­it-dri­ven world which is always in dis­e­qui­lib­ri­um. Until econ­o­mists and pol­i­cy mak­ers rec­og­nize this, we are like­ly to have poli­cies that address symp­toms but not caus­es, and ulti­mate­ly make the prob­lem worse rather than bet­ter.

If we are to address the real caus­es of the GFC, then pol­i­cy mak­ers have to con­front the prob­lem of an out of con­trol cred­it sys­tem that drove mort­gage debt up by a fac­tor of five and turned the Aus­tralian hous­ing mar­ket into the world’s last sur­viv­ing Ponzi Scheme.

Then again, it is most like­ly too late – the cur­rent fren­zy of house buy­ing and house price growth is com­plete­ly decou­pled from any sense of scarci­ty in the mar­ket, and has all the signs of a bal­loon about to burst.