Friday 9 November 2012

More on Housing Affordability: Supply versus Demand

Over at TVHE, Matt has followed up on my post here on Gareth Morgan versus the Productivity Commission, arguing that we shouldn't view supply and demand explanations as mutually exclusive. Now I think Matt and I are pretty much in total agreement, but slight differences in language might make our posts seem at cross purposes, so I thought a couple of clarifications are in order.

First, the interesting question is not whether the cause of house-price inflation in New Zealand is supply, demand, or some combination of both. Obviously, since house prices are set by mutual agreement between buyers and sellers, prices are always and everywhere the result of both supply and demand. Rather the issue is, to the extent that house prices are inappropriate for some reason, whether the source of the inappropriateness is acting through supply or demand. Matt frames this by asking whether something is pushing demand for housing beyond what is "socially optimal" (or, by extension, restricting supply below what is socially optimal). Another way of saying this is to ask whether the policy response to high house prices would work by increasing supply (say changes to zoning or consent processes) or demand (say, changes in the tax treatment of housing).

The second clarification is that saying that supply and demand are not mutually exclusive is more than just saying that influences on both sides can contribute to the final effect. In the case of tax policies, the purpoted cause of house-price inflation only makes sense if there is an underlying problem with supply. To illustrate, consider Matt's statement
The key point against supply side issues will be fact that rental growth hasn't gotten as scary at any point -- if there are "too few" houses, then we should really see the cost of housing services/rent pick up.
The idea here is that if house prices are going up faster than rent, then the opportunity cost of owning a rental property must be rising faster than the direct income derived from it, so the only motivation must be the expectation of capital gain. This is true, but the expectation of capital gain only makes sense if the underlying trend is for the demand for housing for non-investment purposes to grow faster than supply. That is, to explain house inflation today as driven by tax-favoured investment, we need to assume a problem with restrictions on supply in the future.

Furthermore, consider what we would observe if there were no favourable tax treatment for owner-occupied housing or income derived from capital gains, but still an expectation of demand growth outstripping supply growth in the future. As long as the capital gains tax rate were not set at 100%, it would still be the case that expectations of future house price inflation would drive inflation in house prices today, there would be a positive after-tax return from capital gains, and hence a slower rise in rents, exactly the observations that Matt suggests might imply the problem is not exclusively on the supply side.

The bottom line here is that the favourable-tax-treatment story simply implies that problems due to insufficient supply will bite a bit earlier than they otherwise would have done. If there is no problem with supply being unable to keep pace with underlying demand, the tax-treatment issue is irrelevant.


  1. If you look at the data from REINZ and track the number of sales compared to the number of dwellings (installed base) there has been a major shift in the level of turnover in the market - liquidity, to the extent that it exists in the housing market, has fallen dramatically over the past few years... so where the turnover was about 6% of the installed base from 1992 through to 2008, since then it has fallen to around 3.5%.

    So another explanation could be that because turnover in the market has been a lot lower than previously, then the problem could be one of delayed demand - in other words, demand that would have been there a couple of years ago wasn't because of the GFC and general uncertainty...

    So now we have rising demand simply because people have delayed their plans to a later time - and that later time is occurring now - interest rates are low and will be so for some time yet... so the incentive to transact now has risen...

    Turnover is still quite low, but combined with tight supply (the other side of the turnover issue is that there is still a large group of people who don't want to sell) the result of the sums is rising prices.

    Also note that it is really only Auckland and Canterbury that are seeing any sustainable increase in prices... so demand is excessive in these two areas but elsewhere supply and demand are more balanced...

    The policy response is complicated - does the Reserve Bank stamp out house price inflation in Auckland and risk deflation in the rest of the country or does it allow Auckland to see price growth and only start to put the squeeze on when the rest of the country starts to see the same sorts of price pressures??


  2. Bruce: On turnover, I am not sure what to think about how low turnover might relate to price changes. I suspect that low turnover is related to price uncertainty due to a combination of risk aversion (people changing houses are reluctant to buy first and sell later in case prices fall, or sell first and buy later in case prices rise) or uncertainty aversion (people entering or leaving a market are reluctant to buy or sell at the current price in case it turns out to be over or under valued). But low turnover implies an equal reduction in demand and supply, and so doesn't have a clear implication for price.

    The fact that it is really only Auckland and Canterbury that are seeing house price inflation is a strong pointer at the supply story: the ongoing issue with the town belt in Auckland, and the failure to respond to the earthquake by opening up more land for development in Christchurch.

    Finally, on the Reserve Bank. I have never been comfortable with the idea that house inflation (or asset inflation in general) is something that should exercise a central bank. I guess one could make a case for trying to burst a bubble, but that would require a model that can definitively tell you when you are in a bubble, which is difficult pretty much by definition. But if the asset inflation reflects an underlying trend in fundamentals, such as housing land not keeping pace with population growth, I am at a loss to see what a central bank can or should do about it.