Economic capital is like pornography - you know it when you see it

There are two parts to this blog post. First the important stuff, clarifying the weirdness of capital and the confusion of applying economic concepts in practice. Second is a rant about where the weirdness and confusion comes from, and I point the finger at the intellectual laziness of the economics profession.

Important stuff
Read the below quote. Actually, read it twice. And think about it.

Genuine foreign investment, such as the building of factories and infrastructure, adds to the nation’s productive capacity and employment, and should be encouraged. By contrast, merely transferring ownership of an existing asset to foreign interests is akin to “selling the family jewels”. It does nothing to improve the economy and living standards, and should be discouraged.

This is from a recent post by top economic commentator Leith van Onselen at MacroBusiness. On the surface it makes sense. We want investment in new buildings, machines, infrastructure and equipment. And when foreigners want to makes those investments in Australia, that’s terrific.

But we don’t want to “sell the farm” to pay for it.

The thing is, net foreign investment in productive infrastructure, of machinery, building materials, and so forth of the type that Leith explains adds to our productive capacity, always exactly matches the net sale of domestic assets to foreigners.

The bold terms are crucial, for they reveal the accounting identity at the heart of the matter.

You see, capital account surpluses indicate that a nation sold more assets to foreigners than they bought foreign assets. A capital account surplus is balanced out by a current account deficits, which means that as a nation we imported more goods and services than we exported. Having a current account deficit requires selling assets to foreigners as payment for the net imports of goods and services which contribute to our capital stock.

As I said recently, the term foreign investment is “an idiotic and misleading term for a capital account surplus. It should be called balance of trading assets for goods and services.”

Capital in the external accounts is by definition not physical stuff. It is a set of institutionalised rights. Capital in economics, however, has been hijacked to mean physical stuff, which I show below provides very little guidance for answering important economic questions.

The rant
The blame for this confusion lies squarely with the economics profession. Not only do they routinely confuse the “capital” (K) in their models with capital in the common parlance used to describe funding and asset ownership arrangements, but they also think in terms of a world where there is no distribution or trade in asset ownership; all resource use is directed by a benevolent central planner.

At best capital is like pornography - ‘you know it when you see it’. In Christopher Bliss’s introductory comments to his book Capital Theory he notes

It is a fallacy to suppose that if we have a name for something there must be something, particularly a single something, which that name defines.

The textbooks are no help at all. In one textbook I have, by Frijters, Dulleck and Torgler, all I get is “physical capital includes machines, buildings, roads, harbours airports etc.”

Ricardo arguably began this tradition of capital as stuff stating that

Capital is that part of the wealth of a country which is employed in production, and consists of food, clothing, tools, raw materials, machinery, necessary to give effect to labour.

Or perhaps it was John Stuart Mill

What capital does for production, is to afford the shelter, protection, tools and materials which the work requires, and to feed and otherwise maintain the labourers during the process. These are the services which present labour requires from past, and from the produce of past, labour. Whatever things are destined for this use—destined to supply productive labour with these various prerequisites—are Capital.

Mankiw’s macroeconomics text has a similarly naive and brief definition, stating that capital “... is the set of tools that workers use: the construction worker’s crane, the accountant’s calculator, and this author’s personal computer.” And later, “the capital stock is the quantity of machines and structures available at a given time”.

The fundamental economic elements of capital seem to be:

1. They must be produced physical objects that last a non-zero period of time 
2. During that non-zero period of existence they must be an input into productive activity 

If that’s all there is to it then how can there be any non-capital goods produced? After all, food produced in one period is an input into the sustenance of productive labour in the next period. How can we walk around classifying objects as capital or consumption goods?

Look at the image below. A trained economist would call the bikes on the left consumption goods. But that same economist would turn around and call the ones on the right capital, since they are used as inputs into future production of bike hire services. Yet the ones on the left are also inputs into future cycling services as well! 

Where does that leave the core mainstream economic models? Say, the production function?

The equation below is typically used to introduce the idea of a production function, that say that output (Y) is a function of capital inputs (K) and labour inputs (L) in their strict physical economic definitions.

Y = f(K,L)

Yet if capital is everything except labour, then we can translate this equation to mean

“stuff produced is the product of labouring with other stuff”

Capital becomes merely a residual of inputs after labour (or is that just human capital?).

Once you are indoctrinated into the world of capital as physical objects, there is no where to go to explain deviations from your beliefs except in physical terms. If the model deals with physical stuff, changes in factor payments, wage levels and returns on ‘capital’ (which is quite clearly not physical stuff, since I've never seen a road or machine get paid), or even growth in output, must be the result of some mystical changes in the physical properties of stuff.

To explain these phenomena in this framework one must invoke the idea that objects have some special characteristic of being objects - a technology of objects - that allows them to transmogrify in particular ways that change their physical nature. Computers must compute more computely, and cars must drive more drively for growth to occur. And when these objects become more objecty they are then able to earn a higher ‘factor return’. Better computers bargain for better wages.

Economists are then naturally inclined to look for physical explanations of every social phenomena rather than institutional explanations. Maybe we are having a great stagnation, where objects are somehow unable to transmogrify as successfully anymore. Or maybe we are looking for physical answers to non-physical questions?

Problems with the physical object view arise in estimates of productivity (total factor or labour). The world of physical production is the fantasy world of the neoclassical production function. Some statistician is walking around pretending to measure physical quantities by looking at prices, classifying arbitrarily different objects into a stock of capital, pretending that the world rents every bit of capital from aliens, ignoring almost all the physical capital that is not in corporate accounts (like clouds, oceans, the atmosphere, mineral reserves) and stirring the Excel spreadsheet pot until a single number drops out.

When you read about the fall in Australia’s multi-factor productivity, you should laugh at the incoherence of everyone who pretends to know what it means, and feel sad of those who prescribe their own ideological remedy to the problem of a made up number going the wrong way.

You see, a negative change in multi-factor productivity is a puzzle for the production function view of the world. Does it mean we are so stupid that we combine stuff to make new stuff less effectively than we did last year? Are we getting dumber? Or is our stuff transmogrifying once again, and we are to blame the residual for our woes, and label it with the flavour of the month, like Hicks-Neutral technology shocks or something just as meaningless.

We can then say such profound nonsense as “computers made workers poor”. Okay.

Rant over.

Praise the lord! Recite the Economic scriptures

One feature of economics is its uncanny resemblance to religion. When a complex question arises outside of your narrow field of expertise, like a priest during confession, resort to the scriptures.

This is especially true for economists of a particular political persuasion, who are immune any empirical evidence that conflicts with their scriptures.

And so it is with economist polls. The University of Chicago Booth School of Business started their “experts panel”, which is the place to go if you want to see a bunch of people say that introductory economics textbooks are almost always right.

The image below shows an example. See? They all find the idea of Nash equilibrium a really powerful lens through which to view the world. I don’t. But anyway.

This craze of surveying a panel of economic experts has now reached Australia, with Monash University and the Economics Society of Australia posing tricky questions to our own high priests.

It’s so lovely that we now get our own beautiful ritual of watching the high priests periodically recite the economic scriptures.

Take the latest example. The question asks about the economic consequences of the government changing the rules around penalty rates (wage premiums) that are mandated for Sunday work (along with late night work and a range of other situations).

As you can see, 80% of the panellists agree that reducing the minimum wages for Sundays in a variety of industries will be “good” for employment and production.

From someone who agrees:

This is a bit of Economics 101 that is very likely to work

And another:

For many people, weekends are not what they used to be, and are just another part of the week. Given there would be a willing supply of labour, and a demand for it from those entities that currently close due to higher weekend costs, there should be a market outcome that suits many.

Sounds a lot like reciting the scriptures to me, without much consideration of the context. Basic questions like - Why are there weekends? Why do the wage rules exist in the first place? What non-market outcomes were desired?

But what about the minority? The 6.5% who didn’t recite the scriptures?

I think it will have almost no effect on overall employment, merely shifting activity from Saturday to Sunday. Its main effect will be to reduce the rent-sharing of workers and normalize Sunday as a regular working day, both to the detriment of workers but to the benefit of large employers. It is hence mainly a distributional issue.

And another:

The fact that there is increasing demand for services on Sunday does not imply that workers should be paid less to provide those services. In fact, one would argue that workers should be paid even more.
…
if longer opening hours on Sundays imply that consumers spend more time and money at cafes and restaurants on Sundays, then the volume of business of these shops in weekdays might decline. If this happens, than the net effect on employment becomes even more difficult to predict.

Seems reasonable to me. After all, people generally have the same annual incomes and expenditure regardless of which days of the week they do the spending. And I doubt that Sunday trading is holding back investment in new equipment that would add to the nation's productive capacity. In fact, it may hinder it.

You will notice that each of the economists on the panel has made a career out of showing why naive “econ101 assumptions” don’t apply to their field of expertise. Yet when asked about an issue outside their field, they resort to the scriptures, as if theirs is the only deviation from the textbook case. This is lazy and not at all scientific.

In general, the best way to interpret these surveys is a chance for economists to pledge their allegiance to the econ-tribe, making the whole effort a clear demonstration of economics as religion.

More unpopular economic opinions

My last post on unpopular economic opinions was actually quite popular.

Here are some more.

1. There is no such thing as freedom. Every right has an equal and opposite obligation on the rest of society to accept that right. I want to walk around naked through the city. What type of idiotic freedom-crushing society doesn’t let me do that. Well, pretty much all of them. Because my right to waltz naked comes with the equal and opposite obligation on others to accept naked people wherever they look.



Since this "freedom=obligation identity" is always true, there are limitless examples to draw from.

My right to peaceful enjoyed of my house and property is an obligation on the rest of society not to interrupt me, to sleep in my bed uninvited, to use my kitchen, to camp on my lawn. 


2. Capitalism is successful not because it is efficient or productive. The amount of duplication of basic services, 25 types of toilet paper, the fact that over 30% of food grown is never eaten, and the massive costs invested in advertising and sales suggest that there is a fair bit of fat that could be trimmed in our economic system.

But capitalism is successful because it is inefficient. It has built in redundancy that creates enormous flexibility. A society with one large mechanised bakery that makes the daily bread for everyone might get points for productivity, but it is risky. A mechanical breakdown, natural disaster, or disease outbreak would all bring the total bread supply to a halt. In a society with multiple competing smaller, but less efficient bread-makers, these risks are greatly reduced.

As Rory Sutherland says:

Competition itself is highly inefficient. In my home town, I can buy food from about eight different places; I’m sure this system could be much more ‘efficient’ if Waitrose, M&S and Lidl were forcibly merged into one huge ‘Great Grocery Hall of The People No. 1306’. I am equally confident that after a few initial years of success, the shop would be terrible. 

So when we teach comparative advantage and specialisation as a great insight from economics, we aren't actually talking about markets and the foundation of competition in a capitalist economy, but a central planner's view of efficiency that is highly risky. One of the puzzle of the USSR was that for all it's economy troubles, it often seemed quite economically efficient in terms of the static allocation of resources.

3. Net foreign investment is an idiotic and misleading term for a capital account surplus. It should be called balance of trading assets for goods and services. 


4. Queuing is often a really good allocation mechanism. Congestion is a type of queuing. The study suggesting that serving the last person in a queue first increases efficiency is stupid. 


5. The amount of human organisation that is determined directly by prices and markets can be rounded to zero. When you consider the vast amount of services and goods that could be priced that aren’t, you realise just how small the effect of the price mechanism is on society.



Don’t believe me? Why don’t we have private property rights and markets for:



Roads. Public spaces. Air space. Oceans in all dimensions. Outer space. Mars. Antarctica. Within family production. Crime and criminal organisations. Government departments including within the military. Firm internal trade and services. All sex outside prostitution. All possible genes and animal species. Sunlight. Wind. 



Add in options contracts for all future rights for all these activities as well and we get the feeling that the story that economics of markets and prices plays a tiny role in human organisation and production. I reckon the scope of possible property rights must be thousands (millions?) of times larger than the actual property rights that facilitate priced exchanges that we have in place. 



Not only that, but prices are way too sticky to be performing the function they are suggested to do in economic theory. Coca-cola was 5c a bottle for 70yrs.

As you might have guessed, Ronald Coase is my favourite economic pioneer.


6. Writing off the $1.2 trillion of US student debt would be costless and probably a good way to stimulate the American economy. It would have the same effect of writing off any debt. 



I say it is costless because it is just a transfer from the owner of the debt to the borrower. So although the students in debt are probably above average in terms of their wealth, those who own the debt are probably even wealthier. Hence it would be a redistribution from the super wealthy to moderately wealthy as well as being an economic stimulant as those student whose debts are written off increase spending on goods and services more, relative the owners of the debt. 



The discussion of this topic on a Slate Money podcast earlier this week totally missed this point about this being an asset transfer. 


Missing: Morality and flexibility in economic assessments

I spoke last week at the EDO LawJam about missing elements in the economic analysis of major projects in Queensland, and across Australia.

Assessment of the merits of such projects typically require some kind of cost-benefit analysis. This analysis is intended to take into consideration the vast array of externalities and second round effects of major mines, ports, rail, and other projects, like casinos, subdivisions, and so forth.

One major problem with these assessments is the sheer ambiguity of the requirements, and hence the quite extreme level of discretion in how to undertake the assessment. Project proponents employ economic guns-for-hire who use whichever method of assessment gives the desired answer. Not surprisingly, benefits alway greatly exceed costs.

My fellow speakers in the night - Rod Campbell and Sean Ryan - shared examples of mining companies sourcing bogus economic reports to massively overstate the social benefits of their proposed operations, only to find them thrown out of court during appeal cases. This has lead to some projects having multiple economic reports; the first commissioned to give an outrageous answer, the next to give an answer that might stand up in court.

There is clearly a problem of outrageous flexibility in the regulations when the same company can commission two economic assessments and get two totally different answers to the social costs and benefits of the same project. In one case the net job creation estimate was inflated by 1,000% compared to their second round report, while the value of State royalties was inflated by 1,800% ($22billion compared to $1.2billion).

But this is not an accident. Major mining and property development projects are the playground of politically connected insiders. Take this example of a mine neighbouring NSW Minister for Primary Industries, Lands and Water Niall Blair’s property, which has “this remarkable dogleg around the minister's property by the mine site”.

Political connections get outcomes in this game, and to keep the game going requires considerable flexibility in the assessment regulations.

Apart from this political element, I spoke about two main points.

1. The neglected moral foundation of economic analysis 
2. Ignoring the value of flexibility 

My point about neglected morality is that any estimate of costs and benefit necessarily makes moral judgements about whose costs and benefits are worth considering. Why only humans? Why only Australians? Also, there are hidden moral judgements about the dollar-for-dollar equivalence of cost and benefits affecting different groups of people in different ways. Undertaking economic assessment without acknowledging these foundations is deceptive.

My second point is that major developments, particularly open cut mines, are irreversible commitments. If at some future point in time it turns out that the site is more profitably and socially beneficial for use in agriculture, or some other use (say a solar electricity generation plant), then we cannot change the use from open cut coal mine back to these alternatives.

But if we stick with agriculture, we keep open the option for alternative high-value uses at future points in time. Thus, when comparing the social costs and benefits of a project like a mine, with a baseline alternative of agriculture, we must value the inherent flexibility of agricultural uses to allow for alternative future uses of the site.

My presentation can be viewed and downloaded from here.

Unpopular economic opinions

1. School is mostly about indoctrination into the national identity. It is also about child care, and for older children, about keeping them out of the labour force. If we were honest we could talk about education policy with this in mind, though no one does (okay, there are some exceptions).

2. Gossip is a fantastic coordination device, allowing us to find like-minded others by bitching about particular issues or other people. The underlying idea here is that “my enemy’s enemy is my friend”, so if someone wants to have a good bitch, they are likely to be similar to you. Could be one factor in homophily observed in social networks. Again, rarely discussed.

3. The tax debate is 99% about distribution, 1% about growth. Don’t let economists fool you with their models that they don’t even pretend capture real phenomena. When they say lower corporate taxes increase growth they are modelling a world without assets where all profits are devoted to new investments in capital equipment.

4. Microeconomics is no more scientific than macroeconomics, particularly when it comes to theory. When people say there is progress in micro they mean in applied psychology, where experiments are widely used, and in empirical work where new data is helping to answer localised questions.

Most microeconomics though is still about markets, where aggregation of individuals is still a huge problem - it’s just a different level of macro.

5. Farmers are one of the wealthiest groups in the country and we shouldn’t prop up their businesses or lifestyles (see chart below). They are not charities and will jack up prices when they can. We can protect food production as an industry by protecting the degradation of the land from incompatible and irreversible uses like mining, housing developments and so forth. But some farm businesses will go broke from time to time and that is not a problem. We also are a massive food exporter, so there is really no “Australian food security” argument. 

6. Speaking of food security, we really overlook the main cause of malnourishment is poverty, not a lack of food production in the aggregate. Making poor people richer by taking from the top few percent of wealthiest and giving to the bottom 20% of the world would solve food security, amongst many other social ills.

7. Redistribution of global wealth is clearly the most obvious policy for a utilitarian. Bloody obvious.

8. Open borders to me seems like a way to pretend to be serious about global poverty and inequality. It allows supporters to pretend that the borders of private property within a nation are moral, yet the borders between nations are not. Somehow if I am denied, through accident of birth, to make a living from my share of the land in my own country, this is a radically different thing to Alex Tabarrok’s view, where he asks “How can it be moral that through the mere accident of birth some people are imprisoned in countries where their political or geographic institutions prevent them from making a living?”

As I have said before, even the wildest proponents of open borders agree that

“…open borders could not on its own eliminate poverty and that international migration could only help the relatively better off among the global poor”

Then what is it really for?

Two-child China, and population ageing myths

China abandoned its one-child policy yesterday. Just about everything I’ve read since explains that this policy shift is a result of fears about dependency ratios; the ratio of the number of non-working age people in the population (children and the elderly) to the number of working age people. As shown in the chart below, China, like most countries, is seeing the start of an uptick in this ratio due to an ageing population.

But the simple fact is that increasing fertility rates isn’t a solution to this problem.

The reason population growth doesn’t solve this problem is that a growing population relies on

1. more children, and hence a higher youth dependency ratio, or
2. more immigrants, who both reproduce (more children) and become elderly themselves. 

The only way population growth can ‘solve’ the age dependency problem is if the growth rate itself continues to grow in a grand human Ponzi scheme.

To make this point clear I have poached the data from a great study way back in 1999 by Peter McDonald and Rebecca Kippen. They simulate a number of Australian population scenarios that represent some of the political views at the time ranging from Harry Recher’s view of a one-child policy coupled with zero immigration, to Tim Flannery’s view that a sustainable long-term population target is 12 million, to Jeff Kennett’s view that immigration should be ratcheted up as far as necessary to maintain a constant dependency ratio.

I show in the graph below the dependency ratio[1] based on the various population projections in their simulations (final populations in 2100 are in brackets).

A few things should be noted.

First, the lowest population projection, the Recher model, gets Australia’s population to 5 million by the end of the century and reaches a peak dependency ratio (DR) of about 2.2. The highest population projection, the Kennett immigration solution, reaches a population of 929.5 million (yes, a billion) in 2100, relying on a population growth rate of over 4% to keep the DR at its 1998 level of about 0.7.

In between these two extremes we have population paths that lead to populations between 12 and 50 million by the end of the century, all of which result in a DR between 1 and 1.5 by this measure.

But here’s the thing. That 0.5 difference in the DR between the radically high and low population projections, can be totally offset by changing the retirement age by just two years - shifting the population at age 65 and 66 from dependent to working age.

At the moment the Australia pension age is shifting two years - from age 65 to 67. If social norms of employment change to accompany this, any ageing problem is already solved.

In short, what seem like insurmountable demographic shifts are actually relatively slow and minor changes in economic terms. Not only does a declining youth dependency ratio offset much of the increase in the age-dependency ratio, but from the perspective of the economy as a whole the potential costs of ageing are minor compared the economic and environmental costs associated with rapid population growth necessary to suppress this ratio.

[1] In these scenarios the dependency ratio is weighted so that a child accounts for 3/4 of a person, and a retired older person (above age 60) accounts for 5/4 of a person.

Queensland will ignore better planning

I wrote a submission during the consultation on reforms to the Queensland planning system. As you are probably aware, my research in this area focusses mostly on teasing out statistically the amount of favouritism happening in high value rezoning decisions.

My submission also focuses on the scope within the proposed Planning Bill for continued favouritism. But I also raise the point that we should enshrine at the highest level that governments of all levels, from Councils upwards, be able to capture the land value created by their planning decisions. As it stands the Bill suggests the opposite should be the case - that Councils are liable for compensation should they downgrade the value of land uses at a location (subject to the land being currently used for that purpose).

In no other area of government do we give away property rights for free, so often. It's a multi-billion dollar annual ritual of gift-giving from the public to politicly-connected landowners.

If you want to listen to a terrific podcast covering the types of mechanisms available to recover value gains from government policy I recommend last week’s Renegade Economist episode, which is the source of the below image as well.

You can download my submission here.

Explaining everything explains nothing: Economics

The below comic probably hits a little close to home for most economists. Poking fun of economists’ naive attachment to their particular brand of rationality, and it’s immense body of hidden assumptions, usually gains responses that are merely signals of tribal loyalties and ignore the substance of the critique.

My colleague Vera te Velde made an improvement on the comic which is also included below, and my reading is that she wants to gain loyalty from the tribe more than defend rationality assumptions in economic models.

While it is certainly true that her improvement is consistent with core economic theories, it really highlights in my mind that these theories are essentially vacuous if they can explain anything and everything imaginable.

In response to the ability of other economists to fit everything within their model (meaning nothing can be excluded), simply because of creatively reversing out a set of preferences that explain the observed behaviour (or as Vera concludes De gustibus non eat disputandum), I wrote

There was simply no phenomena he could not explain with his beloved utility theory. But if the theory explains everything imaginable, then it predicts nothing. I resolved that the theory as it stands, in the revealed preference form, was not falsifiable, though he didn’t seem to understand why that would matter.  

Sure, humans often make calculated decisions, but the more I learn about the nexus between individual behaviour and how we behave in groups, the more I see very little value in rational-individualist views of economic systems that see all behaviour arising from God-given personal tastes. Without acknowledging the necessity of group-coordination mechanisms intrinsic in our behaviour, we are missing the main story.

How to analyse housing markets

Housing costs are typically 30% of household income, while about 43% of household savings are tied up in the value of owner-occupied dwellings. There is really no more important market for the general public to understand when it comes to their cost of living and their ability to save for the future.

But simply talking about the housing market as if it is some monolithic beast will lead you to the error of conflating three distinct markets that must be considered independently to truly understand what is happening. These markets are

1. The land/property asset market
2. The housing service market (annual occupancy from rent or ownership)
3. The residential construction market

When you buy a home on the second-hand market (rather than build yourself), you are actually buying a bundled good which includes a land asset along with a durable housing product that lasts the life of the building. A close analogy would be buying a car bundled with an equity share in the vehicle manufacturer—you get the vehicle for its useful life and the equity asset in perpetuity.

So when we talk of high demand for housing, home prices increasing, and housing bubbles, we must be clear about whether we are 1) talking about the market for the land asset component of the bundled housing good, or 2) referring to the housing service market for occupying homes. Conflating these two markets is the most common error in housing market analysis and leads to conclusions that make little sense.

For example, take the frequent comments about the effect of population growth on home prices. To me, it is utterly confusing. If we are talking about the land asset market, the question then arises about why we don’t talk about the population effects on equity and debt markets, derivatives markets, and other asset classes that could equally see effects. Why would "new" people be willing to pay more for the same asset?

You can see from the graph below that population effects don’t seem to be a major driver of land asset price growth. Areas with a 10-15% population declines have still seen 70% growth in home prices.

Like other asset markets, the reason land prices increase has a lot to do with the reduction of interest rates in the past 20 years. Asset prices are just the capitalised value of future claims on incomes, so a lower interest rate increases that asset value compared to the value of that future income flow. This means that comparing prices of the bundle of house and land asset to incomes makes no sense at all. It would make just as much sense to compare the price of an equity share in Woolworths bundled with a kilo of bananas as a way to measure food inflation. Why not measure the food itself?

Luckily, we do have a market for housing as a produced good that we consume on an annual basis quite apart from the land asset; the rental market. If we measure how much of our incomes we spend on rent, and the quality of the homes we reside in (in terms of area per person), we can apply the supply and demand model to the market. If there really is something going on with population and housing production, it must be observable in the rental market. Looking at the chart below we can see that the rent-to-income ratio declined all the way through the land price boom of the early 2000s. So too did the occupancy rate (fewer people per home) indicating that in Australia more new homes were built than needed to house the new people to the same standard.

So sure, use your supply and demand analysis on the market for produced durable housing goods, but remember that home prices are not the price in that market. Rents are the price in the housing market, while home prices mostly reflect asset prices of the land market.

Lastly, we can look at the construction market, which is driven by trends in other markets, including speculation on land markets. Here the supply and demand approach also works, as periods of high demand for new construction result in increasing construction prices (as demand shift to the right against a resource-constrained upward-sloping supply curve for construction services). But again, the construction market and construction prices are not the main contributor to growth in home prices. In fact, higher construction costs will decrease the value of the land asset, as they provide an additional cost to capturing future income flows.

The situation now in Australia is that asset market dynamics, including lower interest rates, international buying by investors whose return is more than just financial (hence will buy with a lower yield), and simple cyclical timing of investments, are driving up land prices in some capital cities. In some areas, when this asset buying occurs in new homes it also increases demand for construction, pushing up prices in that market as well. But in the housing service (i.e. rental) market, the additional new home construction is suppressing rents.

This is the way to analyse housing markets. Don’t be drawn into the monolithic view by conflating behaviour in these distinct markets.

Doing the housing supply maths

Laurence Murphy is a top property economist at the University of Auckland. I met him last night after a presentation in Sydney where he took on the myth that planning constraints are a major determinant of current home prices in Australia and New Zealand.

He said it is very easy to demonstrate mathematically how little impact even a large increase in the rate of supply would have on prices. But when he shows this analysis to government officials, planners, and engineers who have bought into the supply-side narrative their response is often

“I see your calculations. I follow the logic. But I don’t believe it!”

So I wanted to try the ‘basic supply-side maths’ for myself on the blog to see what sort of effects radical changes to the rate of new housing supply could have, and see if I generate some of the same responses.

Here’s how the maths work. I take the number of new dwelling completions from the ABS for the past 20 years, which is shown in quarterly figures in the blue line of the chart below. Since 1995 new housing supply has been 146,546 dwellings per year on average, which is about a 2% increase in the stock annually, though this moves with the business cycle.

I then add 10% to this number every year to generate a counterfactual world where supply has been much higher over a sustained two-decade period (green line). Then I add 20% just to take an extreme scenario (yellow line). Note that in this exercise I don’t ‘elastify’ supply, which would have higher construction rates in boom periods, and lower construction in a slump. When I run the numbers for a more elastic supply that responds more to both booms and slumps I get fewer homes built compared to what actually happened! This is because when the completion rate falls, it falls faster, offsetting all of the gains from the previous boom. I show a 'twice as elastic' scenario in the next graph in red, which actually results in 8,000 fewer dwellings built in the past 20 years. ‘Elastifying’ supply can’t really be what is desired by those advocating for supply-side reforms. 

Any supply-side housing initiative should simply aim to get more homes built, year in, year out. This is what I capture in my counterfactual scenarios of 10% and 20% higher construction over two decades.

So here is the question. How many more houses would there be now in these counterfactual worlds? And what would the price impact be?

Well, if we had built 10% more new home each year for the past 20 years Australia would have around 300,000 more homes. At a 20% higher rate of completions that's 600,000 more. Sounds terrific! That must have a massive impact on prices.

Well. No.

You see Australia’s current housing stock is somewhere around  9.3 million homes. Around 8.8 million occupied, and many second homes, holiday homes, and so forth that are traditionally about 8-10% of the housing stock. These additional homes in my 20-year supercharged supply scenarios represent just a 3.2% and 6.4% increase in total stock respectively.

The price impact of a 3% increase in supply is a 3% reduction if demand elasticity is unity. That’s it. The price reduction could be less if there are countervailing income effects that lead to outbidding for superior locations.  So twenty years of supercharged supply provides somewhere between 0% and 3% lower prices, which suggests to me that focusing on the supply side is close to a waste of time. In the 20% higher housing completions scenario the effect is somewhere between zero and 6%. About the same as two and a half years of rental price growth.

To put it another way, after 20 years of a 10% higher rate of new supply, rents today would be the same as they were in early 2014.

We can alternatively look at the raw measure of the gains to the amount of floor space per person. Taking the average floor size of homes, which is about 180sqm, and adding 3%, and assigning it to the average of 2.6 occupants, to get an additional 2sqm of floor space per person.

Or we can think of it in terms of occupancy rates — the number of people per dwelling — which would be 2.51 instead of 2.6 with the same size homes under the 10% higher supply scenario.

That’s all you get for 20 years worth of sustained housing supply stimulus. And you get none of that simply from more elastic supply only.

The point is that current massive price increases, in the order of 17% per year in Sydney and Melbourne, simply cannot be explained by anything like unresponsive supply. Not only that, any supply-side effect on prices takes many decades to have any effect, and only enters the price equation via effects on rents.

If we want cheaper housing we need to reform legal structures to shift bargaining power to tenants from landlords, curb speculation through financial controls (and keep stamp duties!), and stop rewarding political parties who promise housing supply as any sort of solution to current prices.

Unfortunately, very few people actually want housing to become cheaper. Around 70% of households are homeowners, around 30% are property investors who come from the wealthier part of society, while most politicians also have a huge share of their wealth tied up in residential property. It suits all of these interests to point the finger at supply because they know it sounds attractive in a naive economic way, but won’t actually reduce the value of their housing portfolios.

As Professor Murphy explained, the consensus around new housing supply as a solution to housing affordability problems is a political construct. This unfortunate political reality is best summarised in this tweet. 

  

Politician: I'm want a new housing affordability policy Expert: So u want home prices to come down? Politician: Hell no! #Australia

— Cameron Murray (@Rumplestatskin) September 9, 2015

Dear reader I hope you see my calculations, follow the logic and believe it!