House price signal flashes green

Back in May 2013 I called the end of Australia's slow melt in home prices.  I based this call on a number of market measures, but the crucial one was my own indicator of when to buy and sell housing.  I developed this indicator two years back as a way to capture the potential success of the investment strategy of 'buy on yields, sell on capital gains'. To reflect this strategy I use the ratio of mortgage interest to rental yields to capture the relative returns from yield versus the expected returns from capital gains.

The buy signal arrived at the beginning of 2013.  Since then prices have been rising again in most capital cities, but especially so in Sydney, which dominates the capital city housing prices indexes.  I have updated my chart to reflect this year's data, and extrapolated with predictions for December 2013.

So why is this relevant now?

Because many people who correctly called the overvaluation of Australian housing prior to the financial crisis have ignored the massive transition that occurred during the past five years. The slow melt really did let out the air from the bubble.

Now we have a situation where just about every Australian economic commentator is picking sides in discussion about whether this year's price gains are a new bubble. A former bubble denier has even switched sides.

So why if the data is so plainly showing that we are very far from a bubble, and in fact prices are relatively low right now, why isn't it obvious to everyone? I can think of just a few reasons for confusion.

1. Australian house prices are still high when compared internationally. This argument doesn't really have much merit. Our wages are also higher, and this is reflected in higher rents, which determine the returns on housing assets. 
2. Individual homes in established suburbs seem to keep increasing in price. But this ignores that the relative position of these homes increases as the city grows. Thus what was last decade's cheap fringe suburb in next decades desirable urban location. 
3. Anchoring bias.  $1,000,000 is still seen as some kind of benchmarks of obscene wealth. Yet, the repayments on this loan amount are about 20% lower now than during 2005-2008, while household incomes are up significantly. 

Today's news is that Sydney and Melbourne home prices are up over 5% for the September quarter. Yes, this is a new cycle, but we are only at the beginning and I believe it will be milder in nominal terms that previous cycles.

Thing I wish economists never said

One thing I find surprising about economics is the misuse of models as tools for reasoning.

Think about the basic micro-models. What do they say? They say all markets are in equilibrium. Okay, if that’s the approach you want to take. So how did they get there? Tatonnement? A Walrasian auction. We get there via a central planner who facilitates the equilibrium price before trade is allowed to take place! 

This lack of substance in the fundamental model of markets should beg the question of why markets are preferred over alternative forms of planning? You actually need some other theory to support the assertion that markets are the best resource allocation tools - but such a theory does not exist. 

One problem you face trying to get economists to think deeply about the real life applications of their beloved models is that you have to pretend to take these nonsense models seriously. Don’t be surprised if you get arguments to the effect that real life commercial behaviours must be wrong because the model is right. 

With that short rant over, I want to share a list of phrases and terms that I wish economists never said. These terms illustrate that vacuous nature of economic reasoning, as as you will see, they test the patience of any thoughtful observer. 

Fundamentals

Probably top of the list of things you say when you have no idea what is happening in a market - “we need to look at the fundamentals”. Okay, WTF are they? Just your pet theory? You actually need a deep understanding of the institutional history, legal and regulatory structures of markets, and a decent technical understanding to even know what the fundamentals might be. Plucking an uninformed notion of supply and demand out of thin air is not understanding fundamentals.

Second best

Most people who use this term actually don’t understand its meaning. In the equilibrium model of markets if one market is not in equilibrium, then no other market can be in equilibrium - it’s all or none. The idea of second best is that if in reality there are some markets that aren’t in equilibrium, improving overall outcomes might mean implementing policies that make other markets diverge further from their theoretical equilibrium.

Basically it means that trying to make an outcome perfect in one market might lead to counteracting effects in other market that negate any beneficial effects.

For me this term implies that the equilibrium model of markets is a poor tool for analysis of the economy. However the term implies that market model is first best, and real life is second best - how truly odd to say that.

Bad equilibrium

A assume the economy is in equilibrium. When shit goes bad, assume that the economy is in a ‘bad equilibrium’. WTF does that even mean?

Free market

Really, the ‘free market’ is just a system of highly rigid social institutions that define rights and constrains activities. One frustrating alternative to this phrase is “let the market decide”, which doesn't actually means anything of interest, because markets are merely a product of alternative regulatory constraints. The term creates a diversion from important social issues because it reinforces the assumption that market allocations automatically fulfil social goals, and any interruption of their operation will have costly social repercussions.

The NBN is a great example of this. The social aim is to provide equitable access at a consistent high standard to fibre internet through cross-subsidies between city and country users. The market alternative is that few high value city location will get access to an almost identical service, possibly at lower prices. We decide whether markets are the appropriate tool to fulfil social aims - markets don't decide anything. 

Remember, we can create institutions to produce whatever social goals we have in mind. Market outcomes are great in many circumstances, but they too have social outcome that might justify alternative forms of allocation. 

Shock

As if the regular business cycle, the subject of now centuries of economic research, somehow arises from somewhere external to the commercial activities of society.

Malinvestment

This Austrian economics terminology is both subjective and confusing at the same time. A school of thought that has its own ideas of creative destruction (implying an unpredictable future and therefore lots of poorly allocated capital) somehow expects all capital to be perfectly allocated or this system will collapse? Unfortunately this term provides an excuse to points the finger for economic woes at whatever your pet hate is at the time (usually government involvement in setting nominal interest rates).

Reform

I will let Zac Gross have a go at this one.

‘Reform’ is very sexy word. It is often deployed to cloak policy in feel good vibes and to create an aura of leadership and vision. So everyone in the policy-sphere wants to think of themselves as reformers and many a complete bastard has appropriated this lovely, but overused, title.

Land and housing are durable goods (or why demand/supply framework fails)

The ‘standard’ urban economic model is based on Alonso, Muth and Mills combined work in the 1960s to fashion a mono-centric urban space into an economic equilibrium model. For some reason this model has gained traction in the literature despite it gross misrepresentation of housing markets.

I will let the reader enjoy the comments from David Pines’ 1987 review of the urban economics literature

The static approach in the Alonso-Mills-Muth model is useless in explaining many stylized facts regarding the urban structure and its evolution through time. In the static analysis... land is continuously utilized within the city boundaries and the city boundaries are continuously extended with income and population size.
...
The reason for the failure of the static model in explaining these ‘irregularities’ is that the housing stock is assumed to be perfectly malleable, which, of course, is highly unrealistic. 

What this means is that every time there is a marginal change in any of the parameters of the model - a new person moves to the city, the rental price of the second best land use increases, or the efficiency of construction methods change - the whole city is wiped clean of housing, and the land owners and people sit down around the camp fire and decide a new optimal allocation of housing under the new conditions, then the whole stock of housing is rebuilt in an instant to that new specification. There is never a vacant site or development opportunity. 

Yes, this bizarre model was used by RBA used just a few years ago to help them understand regulatory impacts on housing supply. 

However we have known since 1989, when Bagnoli, Salant and Swierzbinski explored the durable goods monopoly problem posed earlier by Ronald Coase, that the optimal revenue raising strategy of land owners is withhold new supply of housing to future periods to maintain price levels. 

Thus, the constraint on new supply is the number of buyers willing to pay current prices or above in a given time period. If the number of buyers dries up, the optimal solution for the land owner is not to develop until such demand arises. Thus speculative booms are likely to coincide with construction booms, as investors rush into housing markets allowing developers to sell larger volumes of new stock at current prices. 

This point probably needs an example to really drive it home. Imagine you are subdividing a lot into three smaller housing lots. Your market research suggest that $300,000 per lot should be an achievable price. You put them on the market for that price. It takes 4 months to get the price you are after for one block. 

You get offered $280,000 for the second block after another 4 months. But you know that if you accept this price that you will most likely have to accept that price for the third block as well (especially given that sales prices are public records). 

The big question - the one that determines the rate of housing supply - is how long to wait for sales to maintain prices. Do you make a better return if you accept $280,000 and increase the supply now, or is it better to wait until you can get a price of $300,000 and defer new housing supply? 

The answer that Bagnoli found was that if the sellers are more patient than buyers on average (the have lower discount rates), than it is optimal to wait. It is better to sell one per year at $300,000, than 3 per year at $280,000. 

In the mainstream world of AMM’s economic model you shouldn’t have bothered waiting at all. You should have dropped the price immediately until you sold all three blocks on the first day. 

You might want introduce ‘competitive’ land developers at this point. Say my neighbour also subdivides their block into 3 smaller lots. With this less constrained supply surely now the rate of new housing construction will be higher? 

Actually it is not. 

The return maximising strategy is for each land owner to wait, and still sell just one of the now 6 potential lots each year. The land owners compete with each other for a sale, which encourages innovation in design to better appeal to buyers (to get the sale instead of their competitor), but it doesn’t bring forward supply.

Perhaps a little story from my time with a major residential property developer might help.  Remember the days when people would queue at sales offices for new subdivisions.  By sheer luck we were faced with this sort of crazy demand when we released sales of a new building at the Sunshine Coast.  Early that morning it seemed we would be able to sell the whole building within a day or two. So did we?

Of course not. We crossed all the prices out and wrote new ones 20% higher.  That certainly slowed the sales right down, and it took a couple of years to sell the whole building after that.  We simply did the profit maximising thing of withholding new supply. 

By understanding these fundamental processes at the heart of the housing supply debate it leads to very different conclusions about the types of policies that might trigger increasing housing investment - policies that focus on the discount rate of the land owners. 

This could include rent controls (decreasing future expected returns), incrementally ratcheting up land taxes (decreasing returns from not developing), announcing tighter building height restrictions in future periods (to encourage land owners to develop before the new restrictions are implemented), removing land tax exemptions for approved but undeveloped lots, and more. 

That last one is interesting.  In Queensland developers get a 40% discount on land taxes if they have subdivided a lot, but not sold it.  All this does is provide incentives to withhold land for longer, and the cost of doing so is reduced. Of course, developers will simply change the timing of the subdivision to be closer to the sales (getting approval, pre-sales, and then subdividing). But on average it must be a good move to remove this discount. 

The logic of durable goods means the extensive land banking by developers, which in Australia is currently around 19 years supply at current rates of sales, is actually a rent-seeking strategy - an attempt to buy land at a low price with one zoning, only to have it rezoned for more intensive uses before being developed.  It is not about anticipating supply needs and navigating regulations.

It means that developers stage developments in order to bring forward some construction and make the location more desirable for buyer of future stages.  Staging is about delaying development of new homes. 

Lastly, it means that reasoning of shortages or supply constraints due to land price differentials near zoning boundaries, such as by Grimes and Liang, is faulty at best. Of course differently zoned land at the same location is worth a different amount, because the value of that land is the capitalised income from its highest and best use minus the construction costs of that use. It has nothing to do with expectations of future rents or any such thing. 

I highly recommend reading my previous post in interpreting housing market indicators to fully grasp the potential misinterpretation of housing indicators from using the wrong model.

Thinking like RH Coase

I have often railed against the economic approach to social organisation problems which can be described as ‘assume first ask questions later’. There are too few good economists following more scientific methods of sound reasoning and the reliance on evidence in light of real world institutional structures.

The first approach is often called ‘thinking like an economist’. 

Ronald Coase, who passed away at age 102 earlier this week, was in many ways an outlier in the economics profession. He taught in the the University of Chicago’s Law School, rather than in economics, and was often misinterpreted by his economist peers on important and policy-relevant topics, such as what is known as the Coase Theorem. 

We can see his views in an article he wrote in 2012, at age 101, in the Harvard Business Review.

Economics as currently presented in textbooks and taught in the classroom does not have much to do with business management, and still less with entrepreneurship. The degree to which economics is isolated from the ordinary business of life is extraordinary and unfortunate. 

Coase’s scepticism is so important today, when the dominant ‘economic way of thinking’ is to apply marginalist equilibrium models to ever more obscure situations (a la Gary Becker). Unless one can be certain that the model is capturing the important characteristics of this particular market or social institution, the results of some manipulation to the model will have no relevance to the realities one is trying to understand.

One example of the original thinking that epitomised Coase’s career is his take on durable goods and the potential monopoly power of sellers in these markets. He raised these important questions a mere 41 years ago, yet almost none of the results from the research agenda that sprang up from it have entered the mainstream, and are certainly not found in most undergraduate textbooks. 

You will notice the strong links Coase makes to his descriptive model and ‘business practices’, a phrase you may never read in a whole economics degree. Nor do you much read the phrase “in the twinkling of an eye” to describe the rather arbitrary conceptual compression of time into a single period in economic models. 

One important feature of this and other work is that Coase did not make strong policy conclusions, but conditioned his results and explored reasons they may not hold in reality. 

These reasons were picked up and explored later by Mark Bagnoli and others, who found that certain critical implicit assumptions in Coase’s model were leading to its conclusions. 

Thus the assumption of a continuum of consumers-so innocuous and useful a simplification in other contexts-has proved misleading in the context of durable-goods monopoly. 

They explain that the optimal seller of an infinitely durable good (land) will exercise full market power and perfectly price-discriminate, holding back new sales to the market till future time periods to maintain price levels. They label this strategy for sellers the Pacman Strategy “since the monopolist attempts to eat his way down the demand curve.” 

This improvement and development of theory in the market for durable goods is still detached from empirical testing, but is at least an attempt to maintain links to “business practices” actually employed by land owners. 

Unfortunately, like his work on The Problem of Social Cost, Coase has been repeatedly misinterpreted by other economists. When you read about the Coase Theorem, you are probably reading about George Stigler’s interpretation of Coase’s discussions around social costs (externalities). 

As Coase explains in this interview (at the 0.50) -

It’s not about my work at all. George Stigler, who is a very nice man, wanted to pay me a compliment. So he invented the Coase Theorem, but he named it the Coase Theorem and not the Stigler Theorem.
The reason I don’t like it is that it is a proposition about a system in which transaction costs are zero. Well, that isn’t the way the system actually is. Therefore it is a theoretical proposition. I don’t like that.  

He later laments the difficultly in getting economists to understand reason during the now infamous meeting where he convince some Chicago colleagues of the merits of auctioning radio spectrum. 

All I said that the FCC should award the right to transmit on a given frequency to the person who paid the highest amount for it. To my astonishment this room, which one would of thought would be welcomed it in Chicago, was rejected by them. We went on for, I don’t know how long, and hour or something like that. At the end that time they all thought I was right.

They were very impressed by the fact the I had changed their views. But I wasn’t particularly impressed because all I was doing was stating the obvious. 

Coase relies extensively on real court cases and judgements to describe the apparent arbitrariness of property rights, when examining the judges ruling on Bryant v. Lefever he notes that 

The smoke nuisance was caused both by the man who built the wall and by the man who lit the fires. Given the fires, there would have been no smoke nuisance without the wall; given the wall, there would have been no smoke nuisance without the fires. Eliminate the wall or the fires and the smoke nuisance would disappear.On the marginal principle it is clear that both were responsible and both should be forced to include the loss of amenity due to the smoke as a cost in deciding whether to continue the activity which gives rise to the smoke. (original emphasis) 

Led by Stigler, many economists took this logic and ran with it, turning it into the Coase Theorem, while not fully comprehending that the real contribution of this article is to consider the case where bargaining is costly. 

The key point is that “In these conditions [costly bargaining] the initial delimitation of legal rights does have an effect on the efficiency with which the economic system operates”. He goes on to note that every type of social arrangement, including regulation by means of the “special kind” of “super-firm” that is government, has costs and we should seek social arrangements that minimise costs of cooperation relative to the gains. 

He explicitly says the perfect market model is irrelevant to almost all real social costs. The main message being that property rights are arbitrary constructions and we should consider the social costs and benefits of any changes from a given starting point. Its message was very relevant for legal scholars considering rights for damage claims.

On his work about the Nature of the Firm, he recently noted that firm organisation is really a sociological problem, not an economic problem. Which seems so obvious since internal firm decisions are rarely priced, nor do they take place within an environment of market-style contracts.

Rarely now do we see the type of common sense thinking that the ‘accidental economist’ Ronald Coase showed throughout his long career. In fact, I would be surprised if a Coase was beginning his career today that he would be able to break into the profession at all, given it’s obsession with formalisation of mathematical models, and disdain for verbal reason informed by real world conditions. He joked recently that he made his career stating the obvious.