Affordable housing supply from a market crash

It seems that no matter what the objective market conditions are like, the same lobby groups (the Housing Industry Association and the Property Council of Australia for example) and property spruikers continue to trot out the housing shortage claim in an appeal for government assistance.

If you truly believed there is a housing shortage and hence an affordability crisis, a market crash (price declines >20%) is the best solution. I will outline my reasoning by referring to the appropriate economic models – the same models misused by those who believe that government intervention is causing supply constraints.

Chris Joye, perfectionist, has lead the charge since the completion of the Home Ownership Taskforce report in 2003, bringing attention to the ‘fact’ that the supply of new homes in Australia is not responsive to price change and it is this phenomena that has lead to such a dire shortage (housing apparently has a low elasticity of supply, even though I have yet to see any quantification of the claim). Instead of producing a solid theoretical argument for his claims, backed up by rigorous empirical evidence, Chris instead repeats the same tired old property industry mantra with renewed vigour and wit.

But what of his ‘elastify the supply side’ solution to housing affordability? (from here)

Economists are also cautious. But Joye says they are wrong because he has plans up his sleeve to increase supply by cutting development costs. There are no shades of grey.

But when pressed he concedes his "supply side" case rests on some tenuous assumptions about the political, environmental and urban planning choices that state governments and local councils are willing to make.

Joye's last line of defence is to press his extraordinary achievements and repeat praise from an army of high-profile backers. But some of the conscripted say privately that their interest in Joye's work has been misconstrued as unconditional support. "Quoting people selectively and out of context is going to land him in trouble," says one who wished to remain anonymous. "You just shouldn't do that."

I agree that Joye’s case rests on tenuous assumptions, incongruous reasoning, and no evidence, and I would second the note of caution on his selective appeals to authority as a defense for his ideas. 

My hesitation rests on the imaginative and unrealistic outcome Joye, and the property lobby at large, suggest - that if only Local and State government planning controls, infrastructure fees, and approval processes were streamlined, developers nationwide would be happy to build and sell more new homes, at lower prices.

Sure, that will happen.

And of course, the supply side has been the problem the world over. Hang on, except in Germany where strict lending standards and tax regimes rule out speculation on property prices- though they must have particularly lenient planning controls to keep prices so stable (see an international comparison of price-rent ratios in the figure below).

For those with common sense, we can simply say that if constraints on supply (of which there are none) caused Australia’s property boom, what on Earth caused the contemporaneous housing booms the worlds over? Oh yes, supply constraints irrational bubble investment fuelled by exuberant lending.

Spruikers, please don’t invoke the population growth argument now, or you’ll be asked to defend this argument for property markets around the world, and you know as well as I, that the argument is fallacious.  Population growth can only drive up prices if the new people are willing and able to pay higher prices than the existing population. 

Joye takes his analysis a step further than his predecessors by appealing to the mythical cross swords of demand and supply, a model we all learn in first year economics, yet generally one we fail to completely understand.

For those without an economics background,

1. The economic model where supply responds to price describes consumption goods over the ‘short run’ – a period of time so short that new capital investment cannot be undertaken.

2. The model does not apply to asset prices (remember that land prices, not construction prices, have increased dramatically this past decade) – asset supply, in the form of capital goods, should not be responsive to price, but can be responsive to returns and their associated risk (the price of future productive capacity of the asset).

3. Even if we assume that the above two points are wrong, a declining housing price will not reduce the supply of homes, but will allow prices to ‘reset’ and price growth from this lower base will continue to stimulate supply at a lower price.

But let us examine the three points above as a refresher in economic theory.

Most people with an economics degree still fail to make the (dis)connection between reality and the upward sloping supply curve of classical micro and macro theory. The only reason the supply curve is upward sloping, and hence supply should increase as a response to price, is that businesses are operating at the extremes of their capital capacity – so much so, that the cost to produce each extra good is in fact rising, rather than falling (increasing marginal costs as it is known). But how much does that reflect reality? Simply put, it doesn’t 99% of the time. It is rare that businesses will fail to respond to a situation in increasing marginal costs by not increasing their capital base in the longer run.

If we glance now at point number two, we can further see the absurdity in Joye’s supply elasticity argument. Supply of a given asset does not need to respond to increasing returns – prices can simply rise instead. If asset supply did respond in such a way, we would never see capital gains on the share market, as supply of company shares would continue to be increased in response to minor price changes.  However, in the property context, it is higher rates of return that will increase supply, which can only come about from higher rents, or lower land prices.

Finally, if we ignore all the arguments I have already made, and assume that supply of new homes is indeed responsive to price, then the best way for governments to ensure a high rate of new dwelling supply is to let prices fall. When prices fall, development sites will be forced onto the market and snapped up by buyers at prices far below those paid by their previous owners. These new buyers will be able to profitably build new homes at prices below those seen prior to the crash. We can reset the market at 20% below current prices, and have supply stimulated from that new low price baseline.

The supply elasticity argument fails on its own grounds, and on more rigorous theoretical grounds. Like my previous arguments about subsidizing farmers to protect food supply, subsidizing developers to protect housing supply is the worst move a government can make.  Letting asset markets reset (clear) is the best way forward.