Published in The Age (Melbourne), 19 November 2008
This financial nightmare began with millions of Americans’ dreams of owning their own homes. Their desire to buy a house sometimes exceeded their financial capabilities. But low interest rates tempted them to take out generous mortgages. This gave birth to the subprime mortgage market, which catered to the many low and middle-income earners who wanted to borrow more than they could afford.
We know that since the late 1990s, it has been US Government policy to extend home ownership to people who previously could not afford it. But one part of the US housing market’s history barely gets mentioned in the usual accounts of the subprime mortgage crisis: the combination of house price expectations and land supply policies. These might sound like peripheral factors, but they were key drivers of America’s housing boom and bust.
Let’s put this into historical perspective. Across the US between 1970 and 2006, the average annual inflation-adjusted rise in house prices was 2.3%, according to data collected by the Bank for International Settlements. This may not seem much, but it means that in real terms the average US home in 2006 cost just over double what it did in 1970. Over this period, the market came to expect that house prices would continue to rise forever, and this pushed prices up still further. In fact, prices had been accelerating since the late 1990s.
Experiences of past house price increases fed directly into expectations of future increases. But this does not explain why they increased in the first place. To find out why, we need to look at the US housing market in greater detail.
Actually, there is no such thing as a united US housing market. There are instead a large number of local markets, which are often very different. This year’s Nobel laureate in economics, Paul Krugman, pointed at this distinction when he differentiated between what he called “Flatland” and the “Zoned Zone”. In “Flatland America”, Krugman explained, new housing demand directly led to new housing supply. The cities in Flatland simply grew outwards and built new houses at the fringes. This extra supply kept a check on house prices, which increased only modestly, keeping houses affordable.
But in the “Zoned Zone”, things were more difficult.
In these parts of the country, extra demand could not lead to more supply, since stricter land-use regulations prevented the building of more houses. The only way the markets could react to an increase in demand was with higher prices.
Krugman’s simple but straightforward economic logic has been confirmed by Demographia, an urban research group. In a study of 107 local housing markets in the US, it found that housing was least affordable in the ones most heavily regulated by town planners. Where fewer planning controls were in place, houses were more affordable and house prices were more stable over time.
The different outcomes of strict and more relaxed land-use planning regimes also show on an international scale. Some countries impose highly restrictive land-use controls. The prime example is Britain, which introduced its Town and Country Planning Act in 1947. Ever since, it has limited the growth of cities using a mixture of urban growth boundaries (the so-called Green Belts) and complex planning regulations. The British act has been a major influence on planning policies in many other English-speaking countries, including Australia.
Other countries have traditionally had a more flexible approach to land supply. In Germany and Switzerland, for example, planners were willing to increase land supply for new inhabitants, if only because they wanted new residents to pay taxes into the councils’ coffers.
The result of such different attitudes towards land supply shows clearly in long-term house price inflation. Again using BIS data, inflation-adjusted house prices in Germany and Switzerland today are still near their 1970 levels. But in Australia and Britain, houses are between two and three times more expensive than they were in 1970.
Recently, there has been debate about whether central banks failed to control the build-up of asset bubbles, especially in housing. One could argue that monetary policy had been too loose for some time before the huge increases in house prices and the eventual subprime crisis. But monetary policy was not the underlying cause of the housing bubble. That role falls to restrictions on land supply, which made rising prices the only way to accommodate increases in demand for houses.
For policymakers, the lesson is clear. If they are concerned about housing boom and bust cycles, they have to quash the expectation that house prices will continue to rise. To do that, they need to examine property markets with long records of house price stability, and learn from them how to ensure that when more housing is needed, more can be built.