Housing, the ultimate momentum trade
What will happen next in the housing market? The question comes up all the time in many countries, for an obvious reason: house prices jump around too fast for the good of the economy.
The price hyperactivity does not follow a uniform pattern around the world. Look at the indices of average prices for dwellings by nation, adjusted for inflation, compiled by the Bank for International Settlements. Since 2000, the real average price is up by 63 percent in the UK, by 49 percent in Switzerland and by 12 percent in the United States. The average Dutch price declined by 7 percent. In Germany, though, there has been so little house price action that BIS could only find data back to 2003. Since then, the average German price is down by a tiny 1 percent in real terms.
Basic economic indicators – GDP growth, employment levels and general price levels – can explain almost none of this variation. The patterns in the American and European economies over the last 13 years have been far more similar than the house price trends.
Concrete variations in the balance of housing supply and demand are more relevant, but more for differences within than between countries. Variations in planning rules and demographic patterns have been nowhere near large enough to explain the sharply different direction of house prices.
Finance is more relevant. The amount that people actually pay for housing is closely related to how much money they can get their hands on. That sum is strongly influenced by such financial factors as monetary policy, lending practices and tax rules. These have moved much more than anything in the real economy. For example, tax changes explain much of the Dutch house price fall.
However, financial conditions in developed economies were also fairly uniform from 2000 to the present. Monetary policies were generous and lenders shifted from enthusiasm to caution after the crisis. The main cause of the housing price differences is not supply and demand and it is not finance. It is something more distinctly local: house price psychology.
The current price of housing is largely determined by potential buyers’ answers to questions which are more mental than objective. How much do you care about house prices? What do you think the future price will be? How much of your income will you dedicate to housing? How much of a chance will you take on the dwelling’s future value?
Of course, finance and psychology are intertwined. Lenders will dole out more money as house prices rise, and cheap and large mortgages encourage buyers to bid up prices.
Economists capture the financial-psychological portion of housing prices by dividing the house price into two parts: the cost of constructing a new house of the same quality and the rest. The residual over the imputed construction cost is assigned to the land which comes with the residence.
This land value varies dramatically. The Lincoln Institute of Land Policy and the Wisconsin School of Business have compiled historical data on 46 American metropolitan areas. Their work shows the proportion of the purchase price attributed to land has ranged from 5 percent in Atlanta in 2001 to 89 percent in San Francisco in 2005. In Dallas, the proportion ranged between 13 and 62 percent since 1996.
Anyone who has listened to, or participated in, the fevered discussions of property values during a housing boom can recognise what is going on. In good times, land – the value of housing as a financial asset – looks like a pot of gold in easy reach. Just buy now and cash in later. And anyone who has seen, or felt, the pressure of falling house prices, will know how much panic can be sown by the discovery that the pot is empty.
Gyrations of greed and fear are certainly not exclusive to the housing market. Indeed, all finance is cursed by the perennial return of the false belief that some sort of investment – in tulips, shares, copper futures or houses – can provide great wealth without any serious economic work. The mistake leads to ludicrous prices, ugly behaviour, wasted effort and – when the money runs out, as it always does eventually – to disruptive price crashes.
Land speculation, like any other type of greedy behaviour, is a perpetual temptation. However, cycles of housing bubbles and crashes are not inevitable. Economic discipline can restrain psychological excess.
In practical terms, that means introducing a much less permissive approach to housing finance. The regulation of lenders should aim specifically at moderating price moves – for example, loan-to-value curbs triggered by soaraway annual house price gains. To hammer home the point, the taxes on real capital gains from property should be punitive for existing stock.
Technically, the required changes would be relatively straightforward. Politically, though, they need to overcome a serious obstacle: too many people care too much about where house prices are heading.