A housing market whodunit

Published in Business Spectator (Melbourne), 10 February 2011

My last column about the price stability of German property (The cult of Australian property, February 3) triggered heated discussions among Business Spectator readers. To an audience so used to rising house prices, Germany’s flat housing market was as puzzling as a classic detective story.

Their sense of serendipity led commentators to all sorts of speculations. Were German house prices flat because the rental market was regulated? Was Germany’s infrastructure so good that people could live far away from work? Did large public bodies like railway companies provide cheap housing to their employees?

To help solve their next murder mystery, I would strongly recommend the police get in touch with Business Spectator. With their inquisitive minds, its readers would surely ask all the right questions if put on the case.

As Sherlock Holmes once warned Dr Watson, though, it is a capital mistake to theorise before you have all the evidence because it biases the judgment. So let’s go back to the crime scene, reassess the evidence and then look for the perpetrator. Who killed house price inflation in Germany?

Fortunately, economists have a good toolset for this investigation. Economics, so the saying goes, can be summed up in one word: incentives. If we want to find out why house prices are flat in Germany, we need to understand the driving force behind the high supply of housing.

It’s just like in a whodunit: Who had an interest in supplying the market with ever more houses? And did anyone notice anything suspicious on the German housing market scene?

First, it’s worth noting that there is a related case with many parallels to Germany. House price volatility is virtually absent in Switzerland. Just as in Germany, Swiss house prices have only gone up in line with consumer prices over a very long period of time. In real terms, both in Germany and Switzerland you can still buy houses for prices you would have paid in the 1970s.

Housing supply has been much stronger in Germany than in, say, Britain. In Switzerland it was perhaps even more marked. Had the British built as many houses per capita as the Swiss, they would have completed between 250,000 and 400,000 dwellings per annum over the past decades. In fact, the British were already happy when their supply hovered above the 200,000 mark.

So now that we have two victims in our investigation we still need a suspect. In one sense, Germany and Switzerland do not differ much from other countries with respect to planning. Planning for new housing is a process that happens at the local level. It is mainly local land-use planners and councils that are responsible for releasing land, working with developers and enforcing building standards.

Neither Germany nor Switzerland could be remotely described as streamlined, anarchic or unregulated. Nor do they have lax planning laws or building regulations. If anything, the German Federal Building Code is longer and more complicated than its counterparts abroad. It is certainly not a planning free-for-all.

There is one thing, though, that is very different: In both countries, planners and local politicians know that whenever they make development happen in their areas, they benefit from it financially. And so the reason why Germany and Switzerland have such a strong supply of housing lies in their systems of local government finance.

When Germany’s local politicians want to increase their budgets, there is little they can do directly. Tax policy is made at the state and federal levels of government. There are a few taxes and levies that can be determined locally but the scope for extra revenue is limited.

However, there is one way for local government to improve its revenue substantially: by increasing the number of inhabitants and taxpayers. Through a complicated tax redistribution system, local government receives large chunks of its revenue in the form of state government grants. These grants are directly linked to population figures and tax revenues generated in the area. Thus planning for extra development becomes a revenue raiser for local government.

This system of local government finance fully explains Germany’s very flexible housing supply. Planners and councillors will bend over backward to attract new residents to their areas. When I did research on Germany’s housing market a few years ago, the head of the planning department in a major West German city put it this way: “We are fighting for every single inhabitant. They shall come here and pay their taxes in our city.”

In Switzerland, the link between planning and local budgets is even more direct. Switzerland is probably the most decentralised country on earth when it comes to taxation. There are federal, cantonal (state) and local income taxes. Each tier of government makes its own tax policy and sets its own rates.

In the Swiss model, competition for inhabitants is even fiercer than in Germany. In the greater Zurich region, for example, neighbouring cantons have long been trying to attract the inhabitants away from the city of Zurich with lower taxes. The competing cantons are willing to provide their prospective residents with land for development. Local communities are also happy to welcome the newcomers to their areas. As more taxpayers move into the cantons of Zug and Schwyz just outside Zurich, cantonal income taxes can be cut.

In Switzerland and Germany, intense competition between councils for inhabitants has ensured a steady supply of land for development. Councils do not act as roadblocks to development, as sometimes happens in Britain and Australia. On the contrary, they work in close partnership with developers and prospective residents in order to welcome new taxpayers.

If you are interested in how this work in practice, you may want to have a look at the report I wrote with Alan W. Evans for the British think tank Policy Exchange, Bigger Better Faster More – Why some countries plan better than others.

The strong link between local government finance and housing development fully explains why German and Swiss house prices have been steady for decades. To say it with Sherlock Holmes, improbable as it seems “all other explanations are more improbable still”.

If Australians really cared for making housing more affordable in the long run, they should be studying the German and Swiss experiences more closely.

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