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The cult of Australian property

Published in Business Spectator (Melbourne),3 February 2011

The theory of an Australian housing market bubble shows all signs of a proper religion. There are rituals like the recurring publication of house price indices. There are miracles when house prices rise despite interest rate hikes. Then there are true believers in the theory that Australian house prices are not in any way exaggerated. And finally there are heretics who take great pleasure in questioning just that.

Whether you believe in an Australian housing bubble or not, it is unlikely that any particular set of data will convince you of the opposite. Again, this sounds more like religion than the basis for a dispassionate analysis. The housing market may not yet promise salvation or eternal life but the debates about it couldn’t be fiercer if it did.

Without wishing to upset anyone’s semi-religious feelings, I think it is time to deflate one of the great myths of the housing market. It is the myth that restricted supply is a guarantee for ever-rising house prices.

As undergraduate students of economics learn, lowering supply results in higher prices. But their teachers also issue a disclaimer with this rule. It hides behind the Latin phrase ceteris paribus – ‘all other things being equal’. In their postgraduate studies – and even more so in the real world – the students will then spend most of their time finding out what happens when other things are not held constant.

Applied to the conundrum of the housing market, the ceteris paribus assumption is usually ignored –at least by those who claim that a combination of restricted supply and rising demand for housing will inevitably lead to a rise in house prices.

In the very long run, this is correct. In the short run, however, there is no such inevitability. Why? Because other things are never held equal. Demand fluctuates, expectations change – and then it is the very rigidity of housing supply that amplifies price swings.

As the Unconventional Economist column correctly pointed out (The ‘no housing bubble’ myth can’t last, January 28), “unresponsive housing supply results in greater house price volatility – both on the way up and the way down.” This sounds technical, but the experience of two other countries’ housing markets provides a good illustration of the phenomenon.

The countries in question are the United Kingdom and Germany. On the one hand, they are remarkably similar. Over the past forty years, both the UK and Germany experienced similar population growth, almost identical decreases in household sizes, and comparable economic growth. Besides, both countries have similar population densities.

Summing it up, the UK and Germany share all the factors that explain housing demand. As is so often the case, the Brits and their Teutonic cousins are more similar than the Germans think and the British wish to believe.

However, as comparable as they are with regard to housing demand, they are wildly different in terms of housing supply. For a variety of reasons housing supply was extremely rigid and limited in Britain and extremely flexible and responsive in Germany. The Germans built more houses than the British, both in per capita and absolute terms.

The EU collects data for the housing markets of its 27 member states. According to their statistics, Germany’s rate of dwellings completions per 1,000 inhabitants was consistently higher than the UK’s. In some years the difference was only 10 per cent, in others more than 110 per cent.

The differences in completions were also reflected in the land made available for development. The Cologne Institute for Economic Research calculated that last year there were 50 newly developed hectares of land per 100,000 population in Germany but only 15 hectares in the UK.

So what did these different housing supply circumstances mean for British and German house prices over time? Adjusted for inflation, British house prices rose steeply in the early 1970s and then fell almost as much. German house prices were flat.

Then British house prices peaked again in the late 1970s, only to fall slightly again. German house prices were flat. After that, British house prices rallied until the late 1980s while German house prices remained flat.

Following a massive housing bust in Britain that ended in the mid-1990s, British house prices went on another long rally that ended in 2008. All the while, German house prices stayed flat. Now British house prices have suffered another heavy correction, and – surprise, surprise – German house prices are still flat.

Looking back over the housing markets of both countries, British house prices are now considerably higher than they were 40 years ago whereas German house prices have hardly shifted at all. In the long run, the supply constraints obviously reduced housing affordability in Britain. It is just what economic theory would have predicted.

But the history of British and German house prices also shows something different. Despite the long run house price increases, there were enough ceteris paribus moments in the meantime. They caused strong swings in British house prices because the rigidity of supply sent the market on a roller coaster ride. Booms and busts were programmed into the British market precisely because of its supply constraints.

On the other hand, the flexibility of German housing supply ensured that no such swings could occur. Perhaps it also reduced demand for housing because potential buyers did not expect any future house price increases and thus felt no hurry to rush into the market and buy at all cost. This also explains Germany’s lower home ownership rate. The higher rate of tenants in Germany is a result of market stability, not the cause of it. There are no capital gains to be made in Germany’s boring housing market, so potential owners rather invest their savings elsewhere – and rent.

The British-German housing comparison is instructive in the discussion of Australia’s housing market. It should challenge the religious beliefs in both camps as it shows that rigid supply and strong demand are no guarantee for constant price increases. Though they increase prices over long periods of time, they equally result in strong market swings in either direction.

So is there a bubble in Australia’s housing market? Let’s put it this way: Before the UK housing bubble burst in 2008, the British also believed that strong demand and low supply would ensure ever rising house prices.

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