What if the rules about lending for housing investment limited the size of a loan to an amount based on the rental income of the property rather than its market value? Could such rules constrain wasteful lending growth that simply fuels speculation, and instead encourage lending that fosters long run investment in housing?
Let me take you through one possible version of such rule that I think could ensure that the enormous economic power of new money creation that lies at the heart of our banking system is used for productive purposes.
My proposed loan-to-rent-ratio (LRR) rule is this:
Loans can be made at 80% of the amount where the gross rent of a property covers the interest repayments at an interest rate 2% points above the offered rate.
How would this work?
Imagine a home that rents for $400 per week, or, say $20,000 per year. Mortgage interest rates are 4.5%.
The loan limit calculation starts by asking what size loan can be serviced with $20,000 a year at a 6.5% interest rate (4.5% plus the 2% buffer). This is $308,000. Using this as a benchmark value, 80% of this value can be created as a new loan, which is $246,000.
It is possible to beef up this rule further with a requirement that any remaining payment for the home must come from savings accrued from incomes, not from home equity lending secured against another property asset.
With this rule in mind, we can look at its effect through the property market cycle compared to a rule that restricts lending to a proportion of home values, say 80%, rather than tying it to rental income.
Now
For simplicity, let us start at a point where the market value of our example home is $308,000. Here, an 80% loan-to-value-ratio (LVR) limit would allow lending of $246,000 against this property, which is the same as my proposed LRR rule.
But then the market begins to rise in the property up-cycle.
A year later
Now, the property's market value has increased 15% to $354,000, but the rent is unchanged. Under an LVR limit, a new buyer could now borrow $283,000 (or 15% more). But since the rent has not grown, under the LRR rule, a new buyer could still only borrow the same $246,000. The LRR rule would thus reduce the amount of new funding available during a speculative upswing, where the rise in market value is not matched by a rise in rental income, and therefore dampen the price swing by not increased borrowing and new demand.
During a downturn
The reverse effect happens during a property market downturn. If the 15% price gains reverse, the LVR rule effectively restricts new lending by the same 15% during this market downturn. The LRR rule does not. Again, a dampening effect.
Any downsides to this plan?
The main one is that benefit of lower demand for housing mainly comes in the form of lower prices, which most current homeowners won’t be especially happy about. Banks won’t be happy that their cash cow of new lending is brought under control. Nor will the vested interests of the land-banking property development lobby be happy that their massive stocks of empty land will become worth far less than they thought.
But these are the downsides of any reforms that make housing more affordable. That’s why no effective reforms have been enacted in the past 20 years.
My new book with Prof. Paul Frijters about the grey corruption Game in Australia has been officially released today. It explains how the Game of grey corruption is played, how much it costs us, and what to do about it. In this book you get a much deeper and more comprehensive look at how networks of favouritism form, whether legal or illegal; a view that is informed by our own academic research and that of many others. We also use new economic analysis to show how much the Game costs across some of Australia's major industries, and discuss how we can transform from our current system, to world's best, in each sector.
Read more at gameofmates.com Read Michael Pascoe's terrific article reporting the arguments in the book, and my proposals in my submission to the CCC inquiry into developer donations to councils.
Praise for the book
This book will open your eyes to how Australia really works. It’s not good news, but you need to know it. Ross Gittins, The Sydney Morning Herald Economics Editor
Australians pride themselves on their egalitarianism. But that’s wearing thin. Murray and Frijters are both highly trained dispassionate scholars but their conclusions will shock you. Or I hope they will. If their calculations are even half right you’ll be shocked at how far the Mates have their hand in your pocket! Nicholas Gruen, CEO Lateral Economics
While we are distracted by mythical battles in the Game of Thrones, we are being robbed in the real world “Game of Mates” where the well-connected clip the wages and profits of the hard working. Murray and Frijters provide an entertaining and well researched expose of how privilege and rent-seeking dominates the Australian economy, enriching the Mates in the Game while robbing the rest. And they propose how to end the Game. And they name real names too. This is an explosive and essential book for all Australians. Except the Mates. Professor Steve Keen, Kingston University
If you want to understand what is going in the corridors of power in Australia and how a deep network of insiders are using governments to line their pockets you need to read this book. In my own area of urban planning, the richly documented cases described in the book clearly show how potential public benefit and potential revenue is being siphoned off into arms of selected members of the development industry. Governments need to held accountable for these processes. This book will help Australians understand what is going on – its describes how a small but powerful group of insiders have their noses in the public trough in a range of industries. Professor Peter Phibbs, University of Sydney
About
James is our most mundane villain. His victim is Bruce, our typical Aussie, who bleeds from the hip pocket because of James’ actions. Game of Mates tells a tale of economic theft across major sectors of Australia’s economy, showing how James and his group of well-connected Mates siphon off billions from the economy to line their own pockets. In property, mining, transport, banking, superannuation, and many more sectors, James and his Mates cooperate to steal huge chunks of the economic pie for themselves. If you want to know how much this costs the nation, how it is done, and what we can do about, Game of Mates is the book for you.
On Friday 28th April I am appearing and Queensland’s Crime and Corruption Commission’s Operation Belcarra as an expert witness on relationships between councillors and property developers, and how that leads to favouritism.
A narrow focus
What is interesting from my perspective is how narrow the focus of the inquiry really is. Here are the main objectives from the Terms of Reference:
1) investigating whether candidates in the Gold Coast, Moreton Bay and/or Ipswich 2016 local government elections
a) advertised or fundraised for the election as an undeclared group of candidates, an offence contrary to section 183 of the LGE Act.
b) provided an electoral funding and financial disclosure return that was false or misleading in a material particular, an offence contrary to section 195 of the LGE Act.
c) have not operated a dedicated bank account during the candidates’ disclosure period to receive and/or pay funds related to the candidates’ election campaign, an offence contrary to section 126 of the LGE Act.
2) examining issues or practices that are relevant to the identification of actual or perceived corruption risks in relation to the conduct of candidates and third parties at local government elections, including issues or practices relating to groups of candidates, independence of candidates, election gifts and funding, conflicts of interest or material personal interests by councillors.
3) examining strategies or reforms to prevent or decrease actual or perceived corruption risks in relation to conduct of candidates and third parties at local government elections.
Notice that the inquiry is focussed on narrow technical matters concerning laws about donations, disclosure, candidates negotiating in groups, personal material interests, and so forth.
The important question
The big question is missed: Why are councillors such attractive targets for corruption?
The reason is that councillors have ‘grey gifts’ to offer. That is, they get to decide who wins, and who loses, in a multi-billion dollar game of land rezoning and town planning. I’ve estimated that the value given away in Queensland from such decisions by councils and the State government to be about $2.3 billion per year (read about it in my book).
No wonder councillors are attractive to vested interests. Unlike me, they can make decisions worth billions to others, but that cost them nothing!
A proposal
My proposal is simple. Remove the value of the ‘grey gift’ by selling or taxing it. It’s not hard to do. The ACT has for over 30 years charged landowners 75% of the value gains from rezoning. Doing that in Queensland would raise $1.7 billion a year, and reduce the potential giveaways down to just $500 million. A much smaller pot to share, and one that will attract far less lobbying.
Another alternative is to sell the rezoning rights. Sao Paulo, Brazil, has been doing this for over a decade in certain parts of the city and has raised over $USD 1 billion.
I recommend simply adopting the ACT system here in Queensland. The State could require councils to recover the value increases during the planning approvals process, which would be very easy. It would also deter many speculative planning applications that seek approvals that are far outside the scope of the town plan, as developers who do will end up paying for any extra development rights they get.
Key Points In asset trading markets prices are set through buyer competition
It takes only one extra buyer to bid up the price at an auction, whether they end up winning it or not
Price changes snowball
This month, extra buyers bid up the price. Then next month, they bid prices up from the new higher price that was established last month
Impact on asset trading markets
These two phenomena are why prices in all asset trading markets (where people buy and sell, like most houses and shares), change so much and so often compared to prices of consumer good (that consumers only buy, like most groceries and household items)
Conclusion
Any policy that brings more buyers into the housing market can have large effects on prices (and the same in reverse if you take those buyers away)
Extra buyer effects
In NSW last year, 11% of home buyers were foreigners. But is 11% a big number? What sort of effect on price could that much foreign buying have?
What we know for sure is that 11% of buyers does not mean that the presence of foreign buyers has made prices 11% higher. The price effect could be lower, or far higher. I suspect higher.
One trick to understanding the price effect of additional buyers in the housing market is to understand that potential buyers can affect prices without ever buying a home. It doesn’t matter if the extra buyers are foreigners or investors funded by loose lending. In all cases, not only do the extra buyers who end up buying a home affect prices but so to do other new buyers who didn’t end up buying.
Consider a home auction scenario. The highest bidder wins by exceeding the second highest bid by a tiny amount. But it may well be the case that this one person was willing to bid much higher to buy the property, but didn't have to.
Let's say for simplicity that the winning bidder was willing to pay $1.2 million (it is a Sydney house after all), and the second highest bidder (the under-bidder) was willing to pay $1 million. In this case, the winning bidder need only bid a little over $1 million to win the auction and set the price.
What happens if another buyer shows up at the auction and is willing to pay $1.1 million. They will take up the bidding after the previous under-bidder stops. Pushing the price to $1.1 million by bidding against the person willing to pay $1.2 million. The eventual result will be the same person wins the auction and buys the home, but the bidding process with the extra potential buyer sets the price at $1.1 million, or 10% higher.
What this small example demonstrates is that in a market like housing, additional buyers can influence the price even if they never actually buy anything!
My reasoning, therefore, suggests the price effect of the presence of extra buyers at the margin can have a large effect on prices relative to how many homes they actually buy. This is actually likely to be exacerbated in an asset market like property, as small rises in prices ‘reset’ expectations for future buyers about what the price should be next week or next month. So any small price effect at each auction with an extra buyer in attendance, setting a slightly higher price, is cumulative across the market and over time. These effects are why asset markets can be so volatile and cyclical.
One implication of this is that a sudden reduction in the presence of investors or foreign buyers in the Australia residential property market is likely to have a large negative effect on prices.
Demonstration with auction simulation
To get a feel of the potential size of the price effects from a new group of buyers such as foreign investors, who end up buying 11% of properties, I do the following auction simulations. In these simulations, the new buyers have exactly the same distribution of willingness to pay for homes as local do. The price effect comes from both additional under-bidding and addition winning of bids.
In the ‘before foreign buyers’ case, I draw 89 people out of a statistical distribution of willingness to pay. I use 89 people for the auction so that in the ‘after foreign buyers’ case I use 100, and the new people win the bid 11% of the time on average. The bidders are drawn from a normal distribution with a mean of $1 million and standard deviation of $150,000 to represent the likely willingness to pay in the Sydney housing market.
I then play an auction with the 89 people, where the price paid is the second-highest bid based on the slightly different willingness to pay of each person. The mean winning bid is $1.305 million. It is higher than the mean willingness to pay because the mean potential buyer almost never wins, as they are outbid by the people higher in the distribution of willingness to pay.
The ‘after foreign buyers’ case simply adds 11 extra people to the auction, so that there are 100 people, all drawn from the same distribution of willingness to pay. Here, the mean winning bid is $1.313 million.
That’s 0.6% higher.
That’s not much. In fact, that’s somewhat in keeping with analysis on the price effect of foreign buyers by Treasury. Their analysis looked at price difference between suburbs with high levels of foreign buyers and low levels, to conclude that the price effect of their presence is small. Others have argued similarly.
The cumulative effects
But this is not the end of the story.
There is a problem with my method, and with the method used by the Treasury. Treasury’s analysis assumes that the price effect caused by additional buyers in one area is fully independent of the way prices are set in neighbouring areas. This is unlikely to be true. In my analysis, I assume that the price effect at one auction has no bearing on the willingness to pay of all potential buyers at future auctions. Again, probably not true.
In reality, the prices that are set this week, or month, inform how much every buyer will be willing to pay next week, or next month. After all, where does the willingness to pay come from if not informed by previous prices and how they are changing?
So to get an understanding the total cumulative impact of this larger buyer pool we can take the 0.6% price effect at each auction and compound it to reflect the higher prices becoming incorporated in the willingness to pay of all buyers. There is no clear and correct way to do this, but two options that jump out are to compound weekly (people update their willingness to pay after last week’s auctions), or monthly (the update based on new price information once a month).
If we compound weekly, we get a cumulative price effect of 34.9% over a year. If we compound monthly, it is 7.1%.
What we see is that small effects at the margin matter if they are cumulative, and certainly the effect of more buyers in the property market will have such a cumulative feedback effect on prices.
It is important to note however, that these numbers just demonstrate what could be happening. They are not true of correct, unless by chance my simulation is a perfect reflection of reality. They simply demonstrate the mechanism by which a new pool of buyers who buy 11% of properties can effect prices.
What is definitely not happening is that 11% foreign buying means prices are 11% higher. They probably are higher, but we have no idea by how much. This simulation just shows the sort of range of price effects if 11% of buyers were foreign and they were willing to pay exactly the same as local buyers.
There is also a case where foreign buyers have a different distribution of willingness to pay. Because some foreign buyers may receive benefits from purchasing that are external to the property, like in some cases permanent residency, they may on average be willing to pay more than each local buyer.
If I extend the same simulation account for foreign buyers being willing to pay just 1% more, then the cumulative price effects could be in the range of 14% to 75%. Obviously the higher the difference in the willingness to pay, the much larger effect on prices!
So what?
Unfortunately we can’t say a lot about the real price effect from additional buyers in the housing market, be they foreign buyers or investors. But what we can say is that
The share of foreign buying doesn’t really help understand the price effects very much
Additional buyers will increase the price of properties they do not buy through under-bidding
Small price effects from additional buyers are cumulative if all buyers incorporate the new market price into their future willingness to pay
If foreign buyers have a higher willingness to pay for other reasons, the price effect will be much larger
Standard economic theory says that firms maximise profits, or revenue minus costs. I had always taken this to be a self-evident truth given how entrenched in economic thought it is.
But when we unpick what it really means we encounter problems and contradictions that are rarely discussed, and that undermine the core of the theory itself.
Consider the problem of comparing projects of different sizes. It is well known that the net present value method is not a good way to compare projects with different total costs. Spending $10 to make $10 in net present value terms is far superior to spending $100 to make $11 in NPV terms.
Yet the same logic applies to all the additional costs necessary to vary output in a firm. Each level of output requires different total input costs. Therefore, making a comparison between two output levels must consider alternative uses of any additional costs. Maximising profits without any consideration of the size of the costs incurred to obtain them makes no sense. But this logic still forms the core economic theory of what firms do when they choose how much to produce.
The only way to appropriately compare between projects of different sizes is to fully account for the opportunity cost of any extra costs if they were instead invested elsewhere. In this case, the optimal choice for a project is to produce at a level that maximises the rate of return on all costs, or profits divided by costs.
This is quite similar in many ways to choosing projects based on their profitability index, which is the NPV of future positive cash flows divided by the current costs.
I call this decision process return-seeking, and it is the focus of a working paper I have written with my colleague Brendan Markey-Towler (now published here). What is striking is how different the expected behaviour of a return-seeking firm is compared to a profit-maximising one, despite the relatively minor change in their objective. In general, this helps bridge some of the long-existing gap between the economic model of firm production behaviour, and the empirical realities of firm behaviour.
An example
To further explain this hidden contradiction within profit-maximisation by way of example, consider following the choice of output for a firm.
A firm faces fixed costs of $4, variable costs of $4, and revenues of $10 by producing 10 units of output. Profit is $2, and the rate of return on all costs is 25% (calculated by 10/(4+4) -1). This is shown in Panel A below.
The firm can increase output to 20 units and receive $20 revenue, but variable costs will rise to $13. In this case, profit is $3, and the rate of return on all costs is 17.6% (calculated by 20/(4+13) -1). This is shown in Panel B below.
For the economically-trained it is clear that such a choice is the logical result of a situation where this project has rising marginal (and average) costs beyond 10 units of output, and where the marginal cost curve meets the demand curve (red) at q=20, and where at that point the average cost is $0.85.
It is the standard textbook treatment. And in this standard profit-maximisation view the extra dollar of profit available in Panel B should be sought even though it costs an extra $9 to get it. The extra costs required to earn the extra profits are ignored.
This is a problem.
We are now comparing two projects with different total costs. The correct way to judge whether the choice in Panel B is better is to consider not just Panel A as the opportunity cost, but Panel A plus $9 of investment elsewhere, so that the true opportunity cost of $17 of investment can be assessed.
So let us now take a step back and look how to evaluate whether spending $17 to make more profit by choosing Panel B is worthwhile.
In the panels below I show the project choices with an output of 10 units and of 20 units, in addition to two other project choices, C and D, that are potential alternative investment opportunities in the marketplace. If I now compare the true opportunity cost of the $17 necessary to take option B, I can see that if I had those resources to spend, I could invest in Panel A, C and D together, and make $4.30 profit on my $17.
Also note that Panel C is simply a duplication of the project in Panel A, which is there to make the point that to get double the output without increasing average costs, one can always duplicate their existing capital project.
The point here is that each dollar used to cover variable costs to increase the output of a project could be used to purchase new capital goods instead or invest in alternative projects, which could get a higher rate of return than it does at the margin by expanding the output of the single project.
Where there are alternative opportunities for investment of these inputs costs, the logical thing to do is to make decisions about the output quantities of each capital project based on maximising the rate of return on all costs of each. This way, each scarce dollar is directed most effectively to maximising both its own profit and its overall rate of return. That is, the profit of each dollar of input is maximised. Think of it this way
An intuitive story that clarifies the logic of the return-seeking model starts with imagining that every dollar of cost necessary for a firm to spend on production comes from a different investor. To expand output in the face of increasing cost you need to add more investors, who share profits in proportion to their contribution. You do this only if the overall rate of return on the total costs is increasing. Once you hit that maximum rate of return, adding additional investors to cover greater costs reduces both profits and returns for existing investors.
Overall, return-seeking is actually not much different to the standard view. All it does is make explicit the implicit denominator of fixed capital that exists the short-run profit maximisation model, and say that all costs (not just capital costs) have the option to be capital in alternative projects.
Of course, the standard view can be rescued by assuming that there are no alternative options to spend those additional input costs on. In that case, it is consistent with return-maximisation and is equivalent to having absolutely zero alternative ways to spend those additional input costs.
Making sense of economies of scale
What makes the return-seeking model interesting is that it precludes projects that do not have any economies of scale. If costs are always rising with output, the rate of return on costs can be increased by decreasing the output of the project.
Below I change our example to show a modified project that does not exhibit economies of scale. If output is one, as per the new Panel A, the unit cost is lowest and the rate of return is highest, at 33%. Here, the choice confronting the firm if it wishes to expand output is whether the extra $7.25 in cost necessary to get to Panel B is better spent on investing in nine new extra firms like Panel A, producing one unit each at a cost of $0.75. Clearly producing 10 units of output with ten projects like Panel A is superior, as it makes more profit ($2.50) on less cost ($7.50), and maintains the high 33% rate of return of all costs incurred.
Overall, the view of firms as return-seekers gives a new way to look at how output choices might be made. Indeed, one of the great problems of the standard profit maximisation view is that it rarely matches the empirical record, which includes evidence from surveys of firm managers about their output and pricing decisions. Return-seeking does, in fact, match many of these empirical results more closely, and could offer clues about how to bridge the reality gap between the economic model and real economic decisions.
Read more about return-seeking in our paper, and see some previous blog discussions of this idea here, here, and here.
Prosper Australia has for years been conducting research into how many of Australia’s 9.8 million homes are left vacant. Their major finding is that of the 1.7 million homes in greater Melbourne alone, around 82,000 are vacant, or 4.8%. Their research has been cited by a recent United Nations study on the pernicious effects of the financialisation of the housing sector, and has likely been a key reason for the adoption of a vacant housing tax in Victoria, and probably in Canada as well.
It is timely, therefore, to consider some of the economic and practical realities of vacant housing.
Why keep property vacant?
What gets lost in the hype is this important question. Very few people understand the economic rationale behind leaving homes vacant, as the commonsense view is that a vacant home is always costly since it is forgoing rental income for its owner.
The answer is ‘options’. What I mean here are real options. That is, keeping the home vacant keeps open the valuable option of selling the property vacant and earning a higher price.
Let me explain by way of example.
Say you have a property that could sell for $500,000 if there is a sitting tenant in place, or $520,000 if it is vacant (a 4% price boost from vacancy). This means that the option to sell vacant is worth $20,000.
If you are considering selling in the near future because you want to time your exit from the market, then you may want to forgo rent in order to keep your option of selling vacant open. If the annual rent is $19,000, it might be worthwhile to forgo a whole year’s rent because it is less than the value of the option of selling vacant.
Quite clearly, if you make this decision, you aren’t in the housing market to be a long term supplier of rental housing, but to time your exit and cashing your capital gains.
This is why the financialisation of housing, which encourages speculative buying and selling (getting most of your return from capital growth), rather than long-term investing (get most of your return from rental income), makes housing markets fail in their primary social function of supplying secure housing.
The same logic is at play with vacant land. Given that there is always a positive return to be had from developing land, the very existence of vacant land should be a puzzle. But it is again a real options problem.
If I have a vacant site that I can economically build a 5 storey building on today, going ahead with the build removes my option of making even larger profits from building a 10 storey building in a few year’s time when higher prices make a larger building more profitable. This happens in the absence of any zoning controls, since as prices rise, a larger scale of development becomes more profitable.
So vacant land is only vacant because the landowner is waiting for their development options to increase in value.
But this can be stopped. In my example, if there was a zoning limit of five storeys, there would be no future option of building a 10 storey building, only a 5 storey one at a later date. This makes the value of waiting less, and encourages faster supply.
This is not just my opinion. Here’s an excerpt from a 1985 article by Sheridan Titman who asked this exact question and published his results in a little journal called the American Economic Review, in an article entitled Land Prices under Uncertainty.
It is shown that the initiation of height restrictions, perhaps for the purpose of limiting growth in an area, may lead to an increase in building activity in the area because of the consequent decrease in uncertainty regarding the optimal height of the buildings, and thus has the immediate affect of increase in the number of building units in an area.
A ballpark estimate
The next question is to ask how many homes may be vacant primarily because of this speculative motive. Prosper uses water meter data to asses whether a property has been vacant. By looking at properties that have used no water over a 12 month period (25,000 dwellings), and those that used less than 50L per day over a 12 month period (82,000 dwellings), they make a judgment that these extremely-low-water-use homes are vacant.
To answer how many vacant dwellings there are nationwide we can make a ballpark estimate by scaling up the results of Prosper’s research to other capital cities based purely on the relative size of the dwelling stocks. This method relies on the assumption that if it is logical for owners in Melbourne to keep that share of dwellings vacant, it is equally logical for owners in other states.
The reason to do this, rather than simply recreate the research using water meter data, is that in Queensland and New South Wales, apartments are not all individually metered for water, but metered only once of the whole apartment building. So their approach fails to catch vacant apartments when used in other areas. Electricity usage data, or data from other utilities such as internet and gas, can also be troublesome for this purpose, both in obtaining reliable data from utility companies, and making judgements about what constitutes a vacancy.
When scaling up Prosper’s results from Melbourne we can be conservative, and instead of taking the 4.8% number as the share of vacant dwellings, take a clean 4%. We can also make some other (somewhat) justifiable downwards adjustments for other states where the value of the “vacancy option” is lower because prices have been more stable. The table below shows this calculation.
Total dwellings ('000)
Potentially vacant ('000)
Adjusted
Adjusted reason
Vic
2,507
100
100
None
NSW
3,026
121
121
None
QLD
1,956
78
59
Stable prices means less value from vacancy option (x0.75)
SA
765
31
23
Stable prices means less value from vacancy option (x0.75)
WA
1,058
42
21
Falling prices means vacancy options less valuable when cashflow a priority. (x0.5)
Tas
242
10
7
Stable prices means less value from vacancy option (x0.75)
ACT
164
7
5
Stable prices means less value from vacancy option (x0.75)
NT
84
3
2
Stable prices means less value from vacancy option (x0.6)
TOTAL
392
338
As a ballpark, around 300,000 out of 9.8 million dwellings are likely to be sitting vacant each year, or about 3% of them. For the last five year,s the country has built about 153,000 net new dwellings each year, so these vacant homes represent about two years of new supply at our recent historically high rates of dwelling construction.
So what?
What’s the big deal then? Two things. First, if you think that the supply side of the housing market is a major determinant of prices, having two year’s of new supply already built but sitting vacant is bad. Second, even if you don’t think this much supply has any significant effect on prices or rents (which I don’t, probably around 1-2% at most) then the main rationale for concern is on economic efficiency grounds. These vacancies are a symptom of bad housing policy.
When the housing market turns downwards, much of this vacancy will solve itself as owners look to buckle down to ride out the downturn and generate the rental incomes instead of capital gains.
The historical data from Prosper’s Speculative Vacancies Report confirm this pattern. After the financial crisis their speculative vacancy measure fell from 7% to 4.4% in the following four years, but since 2013 has begun to rise again as property prices started once again began to increase rapidly.
When the next downturn comes, those who are unwilling to accept the price they can get from their option to sell, will probably take the option of renting instead, bringing a massive dose of new supply into rental markets.
In this context, a tax on vacant housing can act as a dampener on speculation, as it makes more costly the speculative option of keeping property vacant. In practice, Canada’s vacant home tax will rely on declarations by owners and spot checks to ensure compliance. This is really the only way. Relying on water data would simply encourage owners to leave taps on to avoid the tax.
But in many ways, speculative vacancies are a symptom of a poorly regulated housing market that is attracting speculative buying (undesirable) rather than long term investing (desirable). We can some of the underlying causes in a much broader way, such as by restricting speculative lending into the housing market in the first place, like by banning interest only loans. With stable prices, only investor buyers looking to earn an income from renting will be likely to invest.
The below presentation by Dr Ole Peters opened my mind. If there was one thing I believed was reasonable about economics, it was the assumption that expectation values upon which agents base their decisions are the “ensemble mean” of a large number of draws from a distribution.
Surely there is nothing about this simple method that could undermine the main conclusions of rational expectations? Surely this is a logical benchmark, regardless of whether actual human behaviour deviates from it.
But now I’m not so sure. Below is a video of Dr Peters making the case that non-ergodicity of many economic processes means that taking the ensemble mean as an expectation for an individual is probably not a good, or rational, expectation upon which to base your decisions.
I encourage you to watch it all.
Let me first be very clear about the terminology he is using. He uses the term ergodic to describe a process where the average across the time dimension is the same as the average across another dimension.
Rolling a dice is a good example. The expected distribution of outcomes from rolling a single dice in a 10,000 roll sequence is the same as the expected distribution of rolling 10,000 dice once each. That process is ergodic [1].
But many processes are not like this. You cannot just keep making the same gamble over time and expect to converge to the mean of the result that you get if you made that gamble independently many times.
An example
Peter’s example is this. You start with a $100 balance. You flip a coin. Heads means you win 50% of your current balance. Tails means you lose 40%. Then repeat.
Taking the ensemble mean entails reasoning by way of imagining a large number coin flips at each time period and taking the mean of these fictitious flips. That means the expectation value based on the ensemble mean of the first coin toss is (0.5x$50 + 0.5*$-40) = $5, or a 5% gain. Using this reasoning, the expectation for the second sequential coin toss is (0.5*52.5 + 0.5 * $-42) = $5.25, another 5% gain.
The ensemble expectation is that this process will generate a 5% compound growth rate over time.
But if I start this process and keep playing long enough over time, I will never converge to that 5% expectation. The process is non-ergodic.
In the left graph below I show in blue the ensemble mean at each period of a simulation of 40,000 runs of this process for 100 time periods (on a log scale). It looks just like our 5% compound growth rate (as it should).
The dashed orange lines are 10 sample runs of the simulation. Notably, the distribution of those runs is heavily biased towards low final balances, with a median payoff after 100 rounds of $0.52 Recall that the starting balance was $100, so this is a 99.5% loss of your original balance.
In fact, out of the 40,000 runs in my simulation, 34,000 lost money over the 100 time periods, having a final balance less than their $100 starting balance (or 85% of runs). Even more starkly, more than half the runs had less than $1 after 100 time periods.
The right-hand graph shows the final round balances of the 40,000 simulations on a log scale. You can read more about the mathematics here.
If almost everybody losses from this process, how can the ensemble mean of 5% compound growth be a reasonable expectation value? It cannot. For someone who is only going to experience a single path through a non-ergodic process, who has a finite budget to play with, basing your behaviour on an expectation using the ensemble mean probably won’t be an effective way to navigate economic processes that are non-ergodic [2].
Peters says the logical thing to do is maximise the average expected rate of growth of wealth over time, rather than the average outcome across many alternatives. In this case, the average rate of growth over time of all runs in the simulation is actually negative 5.03%, meaning it is not a good bet to partake in despite the traditional assessment of expected returns being 5%.
Lessons for Economics
I see two areas of economics where we may have been misled by thinking of the ensemble mean as a reasonable expectation.
First is a very micro level concern: behavioural biases. The whole idea of endowment effects and loss-aversion make sense in a world dominated by non-ergodic processes. We hate losing what we have because it decreases our ability to make future gains. Mathematics tells us we should avoid being on one of the many losing trajectories in a non-ergodic process.
The second is a macro level concern: insurance and retirement. Insurance pools resources at a given point in time across individuals in the insurance scheme in order that those who are lucky enough to be winners at that point in time are able to make transfers to those who are losers. By doing this, risk is shared amongst the pool of insurance scheme participants [3].
Retirement and disability support schemes are social insurance schemes. They pool the resources of those lucky enough to be able to earn money at each point in time and transfer it to those that are unable to.
But there has been a big trend towards self-insurance for retirement. In the US they are 401k plans, and in Australia there are superannuation schemes. The idea of these schemes is that rather than pooling with others at each point in time (as in public pension systems), why not pool with your past and future self to smooth out your income?
You can immediately see the problem here. If the process of earning and saving is non-ergodic and similar in character to the example above, such a system won’t be able to replace public pensions at all. Many earning and saving paths of individuals will never recover during their working life to support their retirement. Unless you want the poor elderly living on the street, some public retirement insurance will be necessary.
Undoubtedly there are many more areas of economics where this subtle shift in thinking can help improve out understanding of the world. I’m thinking especially about Gigerenzer’s idea of a heuristics approach as a generally effective way for humans to navigate non-ergodic processes.
I will leave the last word to Robert Solow, who has had similar misgivings (for over 30 years!) about our assumptions of ergodicity (a stationary stochastic process) which undermine rational expectations.
I ask myself what I could legitimately assume a person to have rational expectations about, the technical answer would be, I think, about the realization of a stationary stochastic process, such as the outcome of the toss of a coin or anything that can be modeled as the outcome of a random process that is stationary. If I don’t think that the economic implications of the outbreak of World war II were regarded by most people as the realization of a stationary stochastic process. In that case, the concept of rational expectations does not make any sense. Similarly, the major innovations cannot be thought of as the outcome of a random process. In that case the probability calculus does not apply.
Footnote [1]. He does not use the term, as it is often used in economics, to describe what is called the term Lucas critique, or in sociology is called performativity. Basically, it is the idea that the introducing a model of the world creates a reaction to that model. Take a sports example. As a basketball coach, I look at the past data and see that three-point shots should be taken more because they aren’t defended well. I then create plays (models) that capitalise on this. But because my opponents respond to the model, the success of the model is fleeting.
Footnote [2]. In theory, if you start with an infinitely small gamble, or have infinite wealth, you could ‘double down’ after a loss in such a process to regain the ensemble mean outcome.
Footnote [3]. Peters himself has a paper on The Insurance Puzzle. The puzzle is that if it is profitable to offer insurance, it is not profitable to get insurance. The typical solution invokes non-linear utility to solve it. Peters offers an alternative. My take is on the economic implications of this is that if people can individually smooth consumption through time for retirement than there is no logic to social insurance.
UPDATE (26/03/2017 9.10pm): On Twitter, it has been mentioned that I have simply restated the logic of the Kelly Criterion. This is true. The logic here, and there, is at odds with the naive way in which odds are translated into rational expected payoffs in economics. In fact, adopting the Kelly Criterion when playing the betting game in the above example generates an expected rate of growth of wealth over time of 8.65%, instead of negative 5.03%, and a far higher and narrower distribution of final period wealth outcomes. The paths of the simulation for betting under this condition, and the distribution of final period wealth, are shown in the below graphs. Notice that this strategy is highly effective at both changing the distribution of outcomes AND increasing the overall rate of growth of wealth. Regardless, the very fact that such a strategy is needed tells us that there is a problem with what a rational expected outcome should be for non-ergodic processes
I spoke on Sunday at an event in Sydney, hosted by Sustainable Australia, called Housing Affordability: An honest debate. A video should be on the Facebook page and is below, as are the notes for my talk.
Imagine explaining 2017 to someone from 1987
I would like to start today by imagining a conversation. It’s the conversation I would have with my grandfather if I could go back in time 30 years to 1987. It might go a bit like this.
Me:
Grandad, how are you? I’m so glad I could come back from the future to tell you all about the amazing progress we have made.
Grandad:
Oh, look at how you’ve grown. What amazing things can you tell me all about it.
Me:
Well, remember how you were the first person out of everyone you knew to fly in an aeroplane? Well, in 2017, people fly all around the world all the time. Not only that, you know how you saw a computer once? Now everyone has a computer in their pocket. It’s like every encyclopaedia in the world has been shrunk down. And we can video call anyone, anywhere in the world, anytime. We have clean solar energy now, and China, South Korea, and many countries in Asia have become wealthy and brought their people out of poverty.
Grandad:
That does sound rather fantastical. And how are you?
Me:
Well, I’m 34 now. I got a university degree, and a PhD, so I’m the first in the family for that. And I have a loverly wife and two young boys who are 6 and 9.
Grandad:
Oh how lovely. You must have a beautiful house and garden then with all those grand things the future holds.
Me:
Well. Actually no Grandad. We live in a house smaller that the one Mum and Dad moved into when they were first married. It’s very similar in fact – I don’t think it has been renovated or improved in 30 years. And our garden? I’ve tried, but I don’t want to put too much money and effort into it. Because I rent Grandad. Although I have a university degree, and so does my wife, we can’t buy a house. They cost $1 million in and around Sydney. Even in Brisbane, homes are around half a million. Less if you go out of town, but it’s hard to find work outside of the city. And we have no chance of saving more than one hundred thousand dollars for a deposit when our rent takes up 40% of our income.
And what’s worse, the price of the average house in Australian capital cities went up 11% last year. In Sydney and Melbourne, the average home went up in price in one year by more than the average wage! So saving up for a deposit is like running up the down escalator. You never make progress!
So we are in a pickle. I can’t have a nice garden, because if we do spend the money and time to spruce it up, the real estate agent will see it and realise that they can rent the house for more, then ask us to pay for it by putting the rent up at the end of our lease. And every year, when the lease is up, we don’t know if we can stay anyway. We’ve moved 4 times in the last 10 years. I don’t really think we will ever have a house and nice garden. Probably not even a nice apartment.
Grandad:
What an absurd situation. You have all this technology – a computer in your pocket, world travel – and you can’t have a place with a nice garden to call your own.
How can we change my story?
Despite being absurd, this conversation contains many truths about modern Australia. And it doesn’t have to be this way. The past 30 years could have taken another path.
By many metrics Australia is one of the wealthiest handful of countries in the world. So why are we having an event today talking about the basic challenge of making housing secure and affordable?
If anyone can do it, we should. Many of our wealthy peer countries have established home ownership is a genuine option, and they’ve made law that make renting a secure alternative.
You see, the heart of this story not about housing, but about economic diversity. When wealthy countries ensure that economic investment is made across many different sectors, they establish demand for skilled workers, demand for cheap housing also comes from the companies who need to attract those workers. Mobility, in terms of households moving cities for work, has declined, mostly because of the challenge of finding affordable accomodation.
We could be in a different place today. We could be talking instead about Australia cementing its place as a global manufacturer of solar and wind energy, one of a our natural advantages. We could be talking about how a world class satellite industry and growing remote sensing industry has revolutionised agriculture, and how we’re exporting this expertise to the world. I could have regaled my grandfather with these wonders instead.
The reality however is that Australia has dropped in the world rankings of economic productivity and diversity. Harvard University researchers called Australia a ‘laggard’ of the Asian region, along with Mongolia and Papua New Guinea. We’ve dropped in their rankings from 32 in 1994 to 54 in 2008, and are still declining. Our exports are now dirt. Mostly coal and iron ore. Canada still beats us, ranked 29, but having declined from being ranked 19 just 20 years ago. Canada too has similar housing affordability problems to us.
As a side note, Canada is second place in the developed world in terms of immigration rates. If Australia just decreased the immigration intake to match the rate of Canada over the past ten years, there would be 1.3 million fewer people. That’s three Canberras!
We can actually see part of the cause of our narrowing of our economic base in the pattern of bank lending. Fundamentally, the pattern of new lending determines the patterns of real investment in the economy. It determines where we invest in new manufacturing and production capabilities, or instead take leveraged gambles by reselling homes to each other. That’s why the fast growing Asian countries use State-owned banks to direct investment towards new production facilities that expand their capabilities.
In the early 1990s, over 50% of Australia new bank lending was for business investment. Only 4% was for investor housing. 25% OO housing.
Now? It’s down to 30% for business. Investor housing has jumped from 4% to 20% of lending, and OO lending too has leaped from 25% to nearly 40%.
But it’s worse. 95% if that massively increase investor housing lending is for established homes, up from 50% in the late 1980s. Only 5% is for newly constructed homes, down from 50% a quarter of a century ago. We are directing our powerful monetary system, our bank lending, away from new investment in new housing, towards trading the same homes with each other. Home ownership rates have steadily declined for twenty years.
Why is this?
In many ways it was a conscious political choice. While the decline of our economic diversity, has failed the average worker, it has been a boon for the landlord class. Those who already own land and housing benefit at the expense of those who want access to housing for their own household security. Those who own the banks benefit too. And we have seen the enormous lengths to which government will go to support the way things are. Every “affordable housing” policy, from FHBG to super access, is designed not to let housing prices fall, and housing become genuinely more affordable.
What can work?
While the main challenge here is political, one thing we can do is have a shortlist of effective policies proposed, analysed, and scrutinised, that are ready to be adopted when the political timing is right.
Let’s start by debunking a furphy. Anyone who says that we need less regulation and freer markets to solve housing affordability is a fool. They have not though this through. They have ignored all the evidence from extensive regulations in wealthy countries that do promote affordable housing. Australia’s problem come in many way from “market forces”.
I’m an economist, I love markets. But I’m not an idiot.
In terms of the larger economic diversity problems, much of this stems from lobbying pressure to sell the assets of the nation to well-connected interests on the cheap, with these new monopolies doing the rational market thing of constraining output and increases prices. No longer do we have a public sector able to use these institutions to take risks, or invest in new technologies that have obvious public benefits.
Public investment has always laid a platform upon which the private sector has built, innovated, and thrived. We know that the space race of the 1960s had huge economic benefits for the economy broadly. We know the many waves of public investment in our city infrastructure also supported private sector producers in terms of transport, communications, water, energy and health. The same is true today. We actually need to defy market forces if we want to make progress. We need to gamble with public investment for major capital projects – yes, like the NBN – for the future.
For example. it’s not too late to do economic CPR on the manufacturing sector if we want to, and that sector will help us invest in the clean energy and information technology future.
Moving on to banking. We should see new lending and money creation, as a social function. It’s a public good. And we have let this money creation gift that we provide our banks to be used to fund land and housing speculation, rather than new businesses and real investment. This is the natural market outcome in the absence of regulations that direct our monetary system is be used for broad economic goals.
We need to massively tighten lending rules for banks to the housing market, and force them to look elsewhere and take risks on genuine productive investment. We could go beyond LVR rules, to loan-to-income rules, that restrict investor lending based on the rental income of the property. We could completely ban investor housing lending except for newly built homes, which do not expand our productive capacity. While it seems extreme, being a wealthy nation where citizens cant afford housing IS AN EXTREME problem!
We should be taxing unproductive activities, and un-taxing productive ones. That means charging for our land and mineral rights. The ACT is six years into a 20 year transition to land value taxation. Loopholes in the PRRT can be closed, and the system expanded onshore as we once tried with the MRRT. As you might now be realising that one of the problems with getting back our economic diversity is the concentration of political power by a few narrow interests. Many came out against the attempt to retain control of mineral right with the MRRT. Expect nothing less next time effective reforms are proposed.
In terms of housing more generally, we could ban foreign purchases altogether. I see absolutely no reason not to. It is clearly a myth that we need the money – after all our domestic lending for housing investment is off the charts! There was around $120 billion if new lending to investors last year. If this was direct to new housing only, it could have funded over 300,000 new homes, far more than one each for our new population over the period. Removing foreign buyers would take a large chunk of the wealthiest potential buyers out of the price-bidding contest for homes. 11% of home buyers in NSW last year alone.
And on the same note, the 50% CGT discount merely serves to increase the payoff from speculation rather than investment and production. It was a mistake. We can admit it. Let’s move on.
Renters
I want renting to be a valid and equal alternative to ownership. To that end my general view is that balance of bargaining power needs to shift towards renters, which would decrease the price-competition that keeps rents high.
There are a number of ways to do this.
Tenancy laws: Remove options for not-fault termination of lease, and limits rental increases. Vacant homes: Introduce a vacant home tax that would punish owners of multiple dwellings, many of which are held for asset speculation, and kept vacant to time their exit from the market and maximise the sale price by selling it vacant. Social housing: Broaden the number of state-owned social housing projects, ensuring they are widely integrated into the community. As well as funding them directly, make them part of development conditions for large new subdivisions. This provides an outside option to renters who are no longer being funnelled into the private rental market.
These laws are absolutely standard across the our peers of successful, wealthy, economically diverse countries, like France, Germany, Denmark. If I were in these countries I could have told my grandfather about my beautiful garden, and I could have told him how we have not had to move 4 times.
Before I finish I should comment briefly on supply. Many people see that as the answer, despite the fact that Australia has the most homes per person that any time in history, and has just had the biggest housing construction boom in history. There certainly has been a small effect on rental prices, in the order of a percent or two less growth here or there. But it has done nothing for prices. Sydney prices are up 75% in 5 years.
Nor does rezoning increase supply. It makes no sense to tell a landowner who has for decades decided not to build houses that they can built more densely. It is a pure gift. There are examples of sites rezoned because of the urgency of supply, only for the developer to turn around and tell investors that they want to take 35 years or more to develop. Sure rezone, but if you are doing it for housing supply, make it a condition that homes are built in a short time period. I have seen developers lobby for rezoning and be granted it due to concerns over housing supply, only to then turn around and tell their investors that the housing development will take 35 years and they will sell as slow as necessary to keep prices high.
Additionally, rezoning rights can be sold rather than given away. In the ACT, rezoning rights are taxed at 75% of their market value. In Sau Paulo Brazil, rezoning rights are auctioned months, and they have raised $10 bill USD in 10 years from that.
I will wrap up now.
I would love to have gone back in time and had a different conversation with my grandad from an alternative 2017. One where there was more to life that speculating on housing, and we could laugh at the idea of housing reality television on our screens. We could instead talk about gardening.
But we can learn from these past decades, and if my grandchildren do the same exercise in 30 years, they can tell me about their family, their work and their garden, and their beautiful home.
In a recent post I explained how home rents are mostly wasted spending arising from futile price competition amongst potential tenants. I likened this to Richard Dawkins’ analogy of energy used to create tree trunks being waste from the perspective of the tree, because the only purpose of the trunk is to win the futile competition for sunlight through investment in height amongst a group of uncooperative forest trees.
I explained how tenants could instead cooperate, by unionising, and exert their bargaining power on landlords to cooperatively reduce rents. This post will look at some examples of how the rental canopy is lowered in practice, and how price competition amongst tenants can be limited by well-written regulations.
The best place to start is wartime. Is such times economic efficiency is a priority, and laws and regulations that cut off wasteful competition are more easily passed.
Almost universally, strict rent controls were put in place across Europe, the US, and Australia, during the major 20th-century wars. These had the effect of containing nominal rental prices despite inflationary pressures from the wartime economic build up. In terms of the primary objective of lowering the ‘rental canopy’, they worked very successfully.
In modern times the main approach to pruning the rental canopy is to enact tenancy laws that restrict the pricing power of landlords for existing tenants. Indeed, almost every wealthy country has laws that improve the bargaining position of tenants, with government agencies tasked with ensuring there is full cooperation amongst tenants, and that landlords cannot sidestep these protective laws. They do this because it works. It reduces rental prices. Even economists know this.
“It is possible to design a set of rent regulations that results in an improvement in efficiency over the unrestricted market equilibrium” Arnott, 1995
Such rules avoid the situation where landlords try to severely hike the rent at the lease expiry, and, if the tenants cannot pay, force them to leave. In the absence of legal protections, landlords are able to squeeze out existing tenants and get new ones at market prices, forcing more tenants into futile price competition with each other. Even the mere threat of this power means that existing tenants are often forced to meet the market price each year. The ‘market’ outcome is that the landlord has all the bargaining power.
In Australia, this situation is the norm. Landlords can increase rents without limit after each contract, typically one year, and ask tenants to leave without any reason at lease expiry.
The graph below gives an idea of how limits on rental increases and a secure rental tenure system can result in tenant paying below market rents. This occurs over time if the rental increase limit is below the growth rate of local market prices. The total value of the benefit from these laws for this example tenant is shaded in grey. For society as a whole, the benefit is the sum for all tenants of the difference in the actual rental price paid to the market rental price.
How big could the gains for Australian renters be if we adopted similar tenancy laws to what is fairly standard n Europe? Let us take the situation of secure tenant rights and coupled with limiting rental price increases to CPI.
In Sydney for example, the housing component of CPI has increased 55% in the past decade, while the CPI itself has only increased 25%. In Melbourne it is 51% and 25%, and in Brisbane it is 50% and 30%. With these figures in mind, a realistic rental price saving of 20% on market prices is possible for long-term tenants in the major capitals.
With $60 billion in total housing rents paid to landlords each year, even small rental savings across a small share of tenants results in big savings. If just one-quarter of tenants made a 20% saving on market rental price, that would amount to $3 billion per year saved. If half of the tenants made those savings, that’s $6 billion.
The security given by these tenant protections also means that tenants are able to invest in improving the property – with curtains, lights, gardens and other beautification projects – without fear of losing their investment because they will soon be forced to leave. Indeed, unlike Australia, tenants are often obliged to bring their own curtains, lights, and sometimes kitchens, when they rent a new home in countries with such well-established tenant protection laws.
Adopting world’s best tenancy rights would undermine futile rental-price competition and be a $3 billion win for Australian tenants.
That’s what I’m calling a class of nonsense policies designed specifically to not address a social problem, but to rake profits from those facing the problem. They disguise a grab for economic rents as a solution. But when you actually think about them as solutions for a specific problem, you meet irreconcilable logical errors that reveal their true nature.
Retirement savings
We know that in terms of real goods and services, private compulsory retirement accounts are useless. We also know that $20 billion per year is creamed off in fees and charges on superannuation accounts. And yet, this bullshit continues.
Error: Buying shares and bonds with superannuation is good, yet buying property with superannuation saving is bad because it inflates prices.
Why: Both are bad. They funnel money into a set of asset markets that would mostly be used instead to buy goods and services and make new investments. The economy is no larger and no more able to support consumption by retirees.
Housing
If you want more housing, your build it. Instead, governments tweak the funding settings for social housing, tweak rules about town planning, buy equity in homes, and provide cash gifts to homebuyers.
Imagine running the military. You want more helicopters. Do you give out helicopter production permits to manufacturers, provide a government guaranteed line of credit to manufacturers of helicopters, buy equity in helicopter hire companies, and give cash grants to people who are buying existing helicopters from each other? No. Because it's bullshit.
Error: Rezoning land to allow greater density is good. Forcing rezoned landowners to actually build homes is bad.
Why: Because these policies are not about supplying more housing. They are bullshit financialisation.
Healthcare
This one is a little more US centric. Instead of simply providing health care, they are proposing to get the government to match payments into individual healthcare savings accounts. It’s bullshit. It’s not an insurance program because insurance only works when you have a diverse pool of participants – you can’t self-insure against catastrophic events, which is sort of the point.
In Australia, money is funnelled into private health insurance using tax system incentives to the tune of $5 billion a year. For every dollar given by the public to the private hospital system, it provides only 40 cents worth of equivalent care compared to the public hospital system. From a health perspective, it's 60% wasted money. So why do it?
Error: People don’t have enough money to pay for healthcare, so to solve that we get people to pay for their own healthcare. Or, we don't have enough money to boost the public health system, so we instead pay $1 of tax money for 40 cents worth of health care in the private system.
Why: Because these policies are not about healthcare, but scraping exorbitant fees for ‘managing’ the money in savings accounts and health insurance accounts.
Privatisation and public-private partnerships (PPPs)
Privatisation, and partial privatisation in the form of PPPs, is about nothing more than removing both debts and assets from the government books, then lying to the public by only talking about the debt side of the equation.
Error: Government has no money, so it sells its assets to pay off debts, leaving it with no money.
Why: Because these policies are about putting monopoly enterprises in the hands of the private sector so that they can make stupidly high profits.
Summary
This is just a taste of the bullshit financialisation in the economy. It is likely to get worse before it gets better.
