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The housing bubble

August 5th, 2003

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.

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  1. Tim Dymond
    August 5th, 2003 at 10:24 | #1

    John, I was speaking to someone who works for the West Australian government last week, who told me that in the Premier’s office there is a belief that WA will not experience a housing bubble burst with the rest of the country. The main reasons are that the big LNG deal with China and new gold mining opportunities will keep up the demand for property. It sounded a bit ‘cargo culty’ to me but sometimes WA is different from the rest of the country. Can ‘big projects’ have the same effect as the Howard put?

  2. stephen bartos
    August 5th, 2003 at 12:06 | #2

    Although the bubble in the housing market, in John’s words “can fairly be described as unprecedented” in the last 100 years, we should not forget that Australia experienced an urban land bubble in the 1890s. That boom was directly implicated in the depression that ensued from the bursting of the bubble. There is a variety of explanations for that bubble, not least of which is the role of speculation and get-rich quick merchants. Australia at present is also seeing a growing number of speculators in the housing market: rather than speculators we call them “residential property investors”. Investors are encouraged in their endeavours by a banking sector willing to lend large amounts of money in what may still prove to be an unwise fashion.

    The fact that the government’s fortunes are to a large extent tied to house prices makes it a reasonable bet for people to expect that the government will intervene if there are any signs of a too rapid bursting of the present bubble. Housing is a sacred cow in Australia; not only is there the capital gains tax exemption, discussed in other posts, but there is no taxation on transfers of wealth (most of which is tied up in housing) on death, and just try to get discussion going on taxing the imputed rent going to owner occupiers and see whether that one flies! This is not to say that the current government policy is wrong on these issues, all policy is doing is reflecting community opinion, which in Australia does value housing highly and does want to see a minimal tax regime applied to it.

    A harsher economic realist than me might be tempted to let the market collapse in order to send a signal that housing is not a one way bet and a path to riches. I disagree – there are too many ordinary people with their savings tied up in housing (whether wisely or unwisely) for this to be a reasonable or humane approach.

    stephen

  3. Dave Ricardo
    August 5th, 2003 at 12:38 | #3

    “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. ”

    For investors, sure, but why would falling house prices be a problem for owner-occupiers?

  4. John Quiggin
    August 5th, 2003 at 13:27 | #4

    ‘For investors, sure, but why would falling house prices be a problem for owner-occupiers? ”

    Negative equity is a big problem – you’re vulnerable to foreclosure, and effectively unable to move.

  5. Homer Paxton
    August 5th, 2003 at 13:39 | #5

    John,
    The Ralph report advocated cutting CGT but the measure was revenue neutral. Are you saying Treasury got it wrong or investors are suffering tax illusion?

    The only way the bubble can burst is for interest rates to rise. I think they should but I can see it happening.

  6. Don Arthur
    August 5th, 2003 at 14:02 | #6

    Why don’t property owners offer long leases?

    If I could get a 99 year lease that I was allowed to transfer at a market price I’m not sure I’d want to buy.

    Of course I wouldn’t want a lease that the owner was allowed to break just because they felt like moving in themselves. And I wouldn’t want the owner of their agent to be allowed to let themselves in every three months so they could bitch about my housekeeping.

    But in return for their giving up these privilages I’d be happy to pay the rates and all maintenance of the property.

    Why is it that I’m forced to choose between hopelessly unsatisfactory short term leases and outright ownership?

  7. Don Arthur
    August 5th, 2003 at 14:03 | #7

    Why don’t property owners offer long leases?

    If I could get a 99 year lease that I was allowed to transfer at a market price I’m not sure I’d want to buy.

    Of course I wouldn’t want a lease that the owner was allowed to break just because they felt like moving in themselves. And I wouldn’t want the owner of their agent to be allowed to let themselves in every three months so they could bitch about my housekeeping.

    But in return for their giving up these privilages I’d be happy to pay the rates and all maintenance of the property.

    Why is it that I’m forced to choose between hopelessly unsatisfactory short term leases and outright ownership?

  8. Dave Ricardo
    August 5th, 2003 at 14:27 | #8

    “Negative equity is a big problem – you’re vulnerable to foreclosure”

    Why?

    Banks foreclose when you stop making payments on your home loan. Why should people stop making payments on their home loan just because market value of the house has dropped? They’ve still got their job, the income from which provides the cash to pay the bank.

    House prices go up and down, but there’s no effect on the cash flow of owner occupiers. A bank would be stupid to foreclose on an owner occupier just because they’ve got negative equity. All this would do is ensure that the bank made a loss on the deal. If the bank does nothing, they will continue getting their interest income and principal repayments. So long as the owner occupier doesn’t become unemployed, the bank has nothing to worry about.

  9. John Quiggin
    August 5th, 2003 at 15:51 | #9

    ‘So long as the owner occupier doesn’t become unemployed, the bank has nothing to worry about. ”

    This is about right, but the converse is that, if the owner occupier does become unemployed, the bank has a strong incentive to foreclose rather than attempting to work through the problems at the risk of increasing their losses. By contrast, with positive equity the bank can leave foreclosure as a last resort with a reasonable guarantee of getting their money back.

  10. Dave Ricardo
    August 5th, 2003 at 16:41 | #10

    “if the owner occupier does become unemployed, the bank has a strong incentive to foreclose rather than attempting to work through the problems at the risk of increasing their losses.”

    Only if the bank thinks that house prices are going to drop even more. But if they’ve bottomed out, banks would have nothing to gain by foreclosing sooner rather than later.

    In any case, why should a house price crash cause a recession? Heavily geared investors will get burned because rents will fall as prices fall, and they won’t be able to meet their repayments, and they’ll be forced into distressed sales, which will force prices down even more.

    Which will be very bad luck for these investors and they might suffer badly, but such is life in the world of property speculation. But why should this send the whole economy into a recession? The number of investors in inner city apartments might be numbered in the thousands, or even tens of thousands, but it’s still a pretty small number in the greater scheme of things.

    And if the economy doesn’t hit a recession, then our typical owner occupier isn’t going to become unemployed, and the bank isn’t going to consider foreclosing on him.

    And if , despite all this, things look like they might get really bad, the Howard put (last seen in operation bailing out his brother Stan’s textile mill) will ensure no one gets hurt (except that poor mug, the taxpayer).

  11. stephen
    August 5th, 2003 at 20:27 | #11

    “why should a house price crash cause a recession?” One reason why large house price falls are likely to trigger a recession – confidence. People who think they are reasonably wealthy spend, people who think their main life asset is decreasing in value stop spending, and the economy contracts. This to my mind is the biggest risk.

    Note – I’d suggest the effect is not confined to investors, it applies to anyone whose main asset is a house.
    stephen

  12. Observa
    August 6th, 2003 at 03:05 | #12

    Well this economic rationalist is pretty much in agreement with the analyses presented here.

    Owning a very marketable house in one of the most desirable beach-side suburbs of Adelaide, I figure I’m pretty long on real estate in a bull market right now. Everything tells me the Smart Money would be flogging off all their real estate assets right now, while the taxi drivers are buying.

    Now I’d love to flog the bricks and mortar to some astute investor and use the proceeds to get long in blue-chip, fully franked shares.(I could even offer the investor a good tenant for 1yr + right of renewal) I reckon I’d leave the banks out of my portfolio as I figure they’re in for some write-downs in provisions for bad debts. Yep, I reckon 1/2million in blue chips for a yr-18 months would see me pick up a real estate bargain then(might even be able to buy back the old joint from a troubled investor, when I tell him I won’t be renewing my lease with him)

    Now if I could just get my missus to see the sense in it for a milli-second.(If she’d only talk to me I know I could convince her) Ah well, it’s nice to dream of blokey things like ice cool entrepreneurial skills, unfettered by the emotional hysterics of women.

    I suppose I’d better B-Pay the bloody rates bill before I hit the sack. ………perhaps a nice cup of tea in bed in the morning might bring her round?

  13. John
    August 6th, 2003 at 07:17 | #13

    “Only if the bank thinks that house prices are going to drop even more. But if they’ve bottomed out, banks would have nothing to gain by foreclosing sooner rather than later.”

    If the borrower is in default, the amount at risk grows with each missed payment. So, if the security is inadequate, the optimal response is to foreclose early.

  14. August 6th, 2003 at 13:14 | #14

    One question that warrants answering is the degree of gearing in over-valued properties.
    This pertains to interest rate risk, the probability of default with every per cent increase in interest rates.
    The low affordability index indicates that interest payments as a percentage of average income are at high levels.
    Rates are at historicly low levels, although they could easily be cut further.
    And growth shows little sign of slumping yet, with wage costs under control, so there is no reason to expect a recession.

    Given the absence of major irrational industrial investments perhaps we can avoid a credit squeeze/recession/bursting asset price bubble scenario.

  15. derrida derider
    August 6th, 2003 at 20:39 | #15

    Substantive policy issues aside (and I agree with Observa that the analysis here is clearer than that in the broadsheet press), the motive for the government making housing policy the “flavour of the month” is more immediate tactics than long term strategy. It’s a pre-emptive blame-shift, trying to make any distress from either the boom or the bust cost votes for the (all Labour) states rather than for the Feds.

    It’s like Howard’s ‘moral’ stance on gambling in that respect, both in its shrewdness and its hypocrisy.

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