How to build rational building expectations?
Published on interest.co.nz (Auckland), 20 April 2015
Last week, the Reserve Bank’s Deputy Governor Grant Spencer signalled that he favours more demand-side interventions in the housing market.
In a speech and in a radio interview he argued that increasing housing supply, though highly desirable, may take too long to have an effect on house prices. Meanwhile curbing demand, for example by means of a capital gains tax, could help to cool the housing market.
Spencer’s views triggered a highly critical response by one of the Bank’s ex-economists, Michael Reddell, who posted them on his blog in a mini series of articles (part 1, part 2 and part 3).
Reddell convincingly points out why Spencer’s focus on the housing market’s demand side is misguided.
It is well worth reading Michael’s posts and I will not attempt to summarise them here. Suffice to say, there are very good reasons to be sceptical about the need for demand-side interventions in the housing market, let alone their ability to effectively reduce house prices.
What I would like to ask instead is a completely different question: Was Spencer right that housing supply is only a long-term solution to New Zealand’s (or rather: Auckland’s) housing problem?
At first sight, Spencer is right. There are roughly 480,000 occupied dwellings in Auckland at the moment. To add between 3,000 to 7,000 to this large figure in a year (as Auckland did between 2007 and 2014), is a relatively minor variation in the total stock. Even if housing supply suddenly surged to, say, 15,000 consented units per year, it would take a while until these homes were built and sold. Correspondingly, it could take a few years until such a supply shock then had an effect on prices.
However, I would still be more optimistic than Grant Spencer that housing supply can produce much quicker price effects. How so? Because of the theory of rational expectations.
Developed in a macroeconomic context, rational expectations theory is a hypothesis that people start changing their behaviour today if they have good reasons to believe something will happen in the future. Say a central bank embarked on a monetary stimulus programme, people might anticipate higher inflationin the future and therefore behave differently today.
In neoclassical macroeconomics, rational expectations theory is typically used to argue that today’s policies do not yield the desired effects because people’s changed behaviour renders some policies ineffective.
However, rational expectations can also be the other way around: By committing credibly to future policies, you could change people’s behaviour today – even when the policy changes have not yet taken place.
Just imagine what would happen if (by some magic) central and local government found a way to guarantee that from 2016, Auckland’s housing market would be flooded with an extra 25,000 houses per year.
If there were no doubts about the implementation of this new, radical policy, it would have an immediate impact on house prices. Why?
If you were an Auckland homebuyer, or a property investor, you would know that future house price increases are now far less likely.
There would even be a possibility that they could go into reverse. If you are rational, you would respond to this plausible scenario by reducing your willingness to pay for Auckland property. As an investor, you may even take your money into a completely different market instead of committing to be burnt in Auckland bricks and mortar.
As theoretical as such reasoning may sound, this is exactly why countries with more price-responsive housing supply sides rarely experience rapid house price inflation.
Germany, for example, in recent years experienced an increased demand for housing; because of the ECB’s zero interest policy, savers were looking for alternative investment options. House prices increased a bit but so did housing supply. And house price increases were not nearly as strong as they would have been in a country with a more rigid housing supply side. The same kind of demand shock in New Zealand would have catapulted house prices into stratospheric heights.
Expectations matter, and therefore the best we can do about Auckland’s housing shortage apart from building more houses is to establish a rational expectation that houses will be built in the future.
In his speech, Grant Spencer said a lot about the importance of supply – and he was right. Unfortunately, the Reserve Bank cannot do much about it. He said some unhelpful things about demand management, and the Reserve Bank should not have a say in that.
In the end, there is only one way to solve Auckland’s housing shortage: By building more homes. Spencer should have underlined this very simple fact even more in his speech. He may have even contributed to a more rational expectation that we will eventually see an Auckland building boom.
Who knows what that could have done for house prices?