The housing bubble
Apparently, the housing affordability problem has been all the rage while I’ve been away. Coincidentally, I’ve been looking at the housing bubble as part of my study of economic policy under Howard. Your comments on this would be much appreciated. Here it is
More than any previous government, the Howard government has tied its economic and political fortunes to the performance of the housing market. Activity in the housing market boomed in the leadup to the GST, as builders and households sought to complete as much work as possible before GST became payable. This boom was, naturally enough, followed by a slump in the immediate aftermath of the introduction of the GST.
The government responded vigorously and effectively, doubling the grant to first homebuyers that had been introduced to offset the impact of the GST. The fact that this measure was available for a limited period fuelled a rush mentality which persisted even after the grant was reduced to its original level.
The homebuyers grant was followed in late1999 by a cut in capital gains taxes., which are now taxed at half the rate applicable to ordinary income. Although this measure gutted an important reform introduced by the Hawke-Keating government, it received the enthusiastic support of the Labor opposition.
Although this measure was meant to encourage participation in the so-called Înew economyâ represented by the then-booming NASDAQ stock market, it had barely taken effect when the dotcom bubble burst. Instead, it helped to inflate a bubble in investment properties, particularly unit developments marketed to small investors who could exploit the benefits of negative gearing (taking tax deductible losses from a rental property in the expectation of realising a concessionally-taxed capital gain).
The direct stimulus was applied to a set of conditions exceptionally favorable to the emergence of a speculative boom in housing. As a result of low inflation and generally expansionary monetary policy, nominal interest rates for housing loans had fallen, in the late 1990s to levels not seen since the 1960s. But financial markets in the 1960s were tightly regulated. Not only was credit generally constrained, but the Reserve Bank was willing to direct banks to reduce lending in areas where the growth of borrowing was seen as excessive. No such constraints apply today.
Although inflation rates have been low for some time, assumptions generated by decades of experience with high inflation have also helped to fuel the housing bubble. For example, it is widely believed that house prices never decline, but at worst remain stable when demand falls off. This has been true in the past because inflation has permitted prices to fall in real, but not nominal, terms. Contrary to popular perceptions, the real price of housing, adjusted for quality, remained roughly stable from the 1950s to the 1980s (Gruen 1988).
A more subtle result of high inflation is that standard long-term mortgage contracts, which appear to involve mainly interest repayments in the first ten years, actually involve a fairly rapid reduction in the real level of debt. For example, with 10 per cent inflation, and a standard 25 year loan, the outstanding debt is reduced by more than half in the first seven years. By contrast, with 2 per cent inflation, only about 20 per cent of the debt is repaid in this period, The result is that homebuyers who take on high debt levels remain vulnerable to relatively modest financial shocks (such as the loss of one income in a two-income family) for much longer than under high inflation.
All of these factors have combined to produce a bubble in the residential housing market that can fairly be described as unprecedented. As measured by the REIA median house price series, average house prices nearly doubled in most Australian cities between 1997 and 2003. http://www.reia.com.au/market_reports/move_issue.asp?iName=APMI%20July%202001-June%202002.pdf &psid=&rd=1 This increase was partly due to increases in house size and amenity and partly due to an increase in building costs fuelled by the boom, but the most significant factor was an increase in the average price of land (ref MRC paper) The Australian Bureau of Statistics gives a more conservative estimate of a 50 per cent in the price of established houses, but this is still an unprecedented increase.
There can be little doubt that the prices of houses and urban land have reached unsustainable levels, and that they must decline in real terms. The main concerns for economic management relate to the speed and extent of this decline. If prices fall 40 per cent over one or two years, which would only bring them back to the levels prevailing in 2000, widespread financial distress is certain and a recession highly probable.
The fundamental difficulty is that, while the Reserve Bank has tried to discourage the speculative boom, it has been unwilling or unable to take any concrete action to stem it. Meanwhile, as the tie between the political fortunes of the Howard government and the boom in the housing market becomes ever more apparent, Australian investors have developed a belief in what might be called the ÎHoward putâ, the belief that, whatever happens to the housing market, the government will come to the rescue.