House prices have exploded over the last few years, especially in rich countries like Canada, the United States, and Australia, where house prices far outpaced other prices, and crucially, much people’s average income. As a consequence, fewer and fewer people are now able to afford a roof over their head in these countries.
So, how did houses get so expensive?
And how does that rhyme with the fact that some pretty well respected economists claim that housing has actually become more affordable since the 1990s because mortgage rates have dropped to historically low levels.
Sadly, if you just watch the regular news, you can find almost any explanation you like, ranging from increased immigration, to increased urbanization, to increasingly expensive building materials, to outdated zoning laws, to increased speculation. In fact, I’d argue that there are now so many explanations out there, that it is, frankly, all getting a bit confusing.
So, to fix that, to provide a bit of clarity if you will, I’ve once again turned to the science of economics and boiled it down to three theories that actually have solid evidence to back them up: a construction failure, excessive speculation, and the general financialization of housing. Together, I found that these three theories can explain the housing crisis in any country. For example, they can explain why while most rich country house prices exploded, those in Japan, Korea, and until recently Germany, decreased. They can also explain how a single city in New Zealand has made housing more affordable in spite of rising house prices in the rest of the country. And, last but not least, these theories can explain why in China, a country where millions of apartments are sitting empty, housing is still unaffordable for most.
But, to make sense of these three theories, we first need to recognize that the housing market is not like any other because a house is at the same time a so-called consumptions good, and a so-called investment good.
So, what do I mean when I say
1 a house is a consumption good
First, let’s start by stating that, obviously, people don’t tend to eat their house. But, they do live in it, and as they do our house gradually becomes worth less, as it gets dirty, damaged, and generally degrades over time. Therefore, you could say that over the years, people slowly consume their home as we live in it.
Now, if a house was just a consumption good, then the economic forces that determine its price should be a really simple function of how many new people there are and how many houses are built.
And this brings us to our first theory, which is that construction has just not been able to keep up with the number of people that need a new house to live in, causing prices to go up.
But, is there any evidence to back up that theory?
Well, to answer that question, we first need to talk about what evidence we should actually look at. In theory this is simple, we should just look at how many houses are being built and then at how many houses would roughly be needed for new people. So, let’s give that a go for some of our biggest housing offenders: Canada, the USA and Australia.
As you can see here the construction of new houses compared to 1977 has been roughly stable, although, notable for Australia, it has increased, for Canada it has decreased and for the United States, it has really slowed down after the 2007 housing crisis.
So far so good. However, sadly, on the demand side, it is pretty much impossible to find out precisely how many houses are needed by a changing population.
Of course, we can look at the total population, revealing that, largely due to immigration, the population of all of these countries increased by quite a lot over the same time period, especially in Canada and Australia.
So, if we then look at new houses being build as a percentage of the population, we can clearly see that there has been a clear long term downward trend for all of these countries.
However, while this chart shows that new house construction per population level has clearly gone down, it doesn’t proof that this means that there are not enough houses in total, given that we don’t know how long houses have lasted in this period. What’s more, just looking at the change in population is not enough because, even if the population remains the same, it could be that more houses are needed because on average people now tend to live in smaller households in these countries. Finally, given that people in these countries have tended to move from the countryside to cities, it could be that while the total number of houses has seemingly remained adequate, a lot more houses in the countryside have effectively become useless because nobody wants to live there anymore.
So, while all of these trends mean that even more houses would be need to be built for the population, we have already seen that fewer houses have actually been built, per person.
So, why did these economies build less and less while they needed to accommodate a rising population?
Well, the most prominent economic explanation I could find for this has been the rise of the so-called NIMBYs, which refers to people that live by the motto “Not In My BackYard,” which means that while they may be in favor of new homes in general, they’d rather have that these would be built in the backyard of someone else.
And, yeah, look, I’m going to be honest, would I be super happy about a big high rise being built next to my sunny garden, no. Would, I then go to my local council to block that development? Well, I hope not. But, I recognize, that this is easy to say, if it isn’t actually happening to me.
In any case, it means that the housing market is suffering from what economists call a collective action problem, in which individual actions, from NIMBYs in this case, while rational from a personal standpoint, lead to a collective outcome that is undesirable, in this case a housing shortage.
Therefore, economists like Noah Smith have argued that the only way to get out of the housing crisis is to prevent NIMBYs from being able to block new housing decisions, for example by moving the power to build from city officials to provincial or even national leaders, or by removing laws that allow NIMBYs to block or at least severely frustrate new developments.
Which, as we have recently seen in the city of Auckland New Zealand can really help solve the housing crisis. You see, while rent in Auckland used to be much more expensive as the rest of New Zealand, the city overruled NIMBY concerns by upzoning roughly three quarters of the cities land, which means that on this land, low-density single family homes could be replaced by high-density apartment buildings. And lo and behold, ever since then, the rent to income ratio in Auckland started to drop, while the same ratio continued to increase in the rest of the country.
A very promising result, from which especially countries with a lot of low density zones like Canada, Australia, and the US could learn a lot.
So, to conclude, the first theory, that the housing crisis is simply a consequence of construction failing to keep up with housing demand makes basic economic sense and, in my opinion, has a lot of convincing evidence to back it up.
However, before we call it a day, and definitively say that our global housing crisis is caused by NIMBYs who are blocking new housing developments, or that if we cannot build more we should limit the number of new people coming in, we need to talk about a piece of data that is contradicting our first theory in several economies.
After all, if a housing shortage is the primary problem, one would expect that in countries with increasingly unaffordable housing, the number of vacant properties would decrease. However, as you can see here for the United States in the early 2000s, even as property prices exploded, more and more properties were left empty.
Similarly, in China, a country with some of the most expensive house prices relative to income in the world, an estimated 7.2 million homes are now sitting empty, slowly degrading.
This phenomenon suggests that if we want to understanding housing markets, we need to recognize the second function of housing, and that is that for many
2 a house as an investment
can explain the strange situation in China where a house price explosion went hand in hand with a construction boom that led to millions of apartment sitting empty. A situation that is really not unique, as it also happened in, for example, Ireland, Spain, and indeed the US in the early 2000s.
You see, while a house to live in obeys the simple rules of economics where increasing prices tends to either lower demand, or, given that everyone needs to live somewhere, not affect demand much, the economics of housing as a speculative investment works a bit differently.
After all, a speculator wants to make money with money. So, if house prices are going up for a while, the housing market actually becomes more attractive for speculators, who recognize that once there is upward momentum in prices, this likely will continue. Therefore, speculators will start pouring in even more money into the sector. Now of course, these new speculators then will drive up prices even more, which again attracts more speculators and so forth.
Luckily though, increased house prices will make it more profitable to build houses, and so a speculative housing bubble is often accompanied by a big construction boom. However, given the positive feedback loop, in many of these cases, even this increased supply is not able to keep up with demand for new investment properties, and because prices are increasing so rapidly, it often makes sense that speculators don’t even bother renting out the place, especially given that laws designed to protect renters often make it difficult to sell an investment property quickly.
Which brings us to the second theory, which is that houses are unaffordable due to a speculative housing boom.
A theory that can be tested by looking at how many apartments or homes are left vacant. But, before we do that, I want to stress that this only works in areas where prices are increasing because, actually, if you look at countries or areas that are experiencing population decline, you will of course, also see increased house vacancies.
So, if we look at house or rental vacancies in some of the booming housing markets we have talked about so far, we can see that it is actually at an all time low? Well, no. Unlike in 2006, vacant properties are actually pretty low in the United States, and most other countries.
Although, there is one exception, Canada, where I could not find any real time data, but I did find reports that record numbers of apartments are sitting empty in major housing hotspots like Toronto and Vancouver.
So, does that mean that, with the exception of China and some Canadian cities, excessive investment in housing is not the main problem right now?
Well, not so fast, because we haven’t talked about our third theory yet, which has been advanced by dr. Josh Ryan-Collins from University College London.
His theory is that the main reason you cannot afford a house right now is because of cheap money, mainly in the form of low interest rate mortgages. And, according him, this all started with good intentions in the 1980s, when politicians wanted to make home ownership more accessible and thus liberalized mortgage markets.
However, if we look home ownership rates ever since, it is not clear that this actually worked. But, as dr. Collins states
‘ since the majority of mortgage loans finance(d) the purchase of existing rather than new property, the inevitable result is house price inflation’
Simply put, imagine that you have a fixed population of people, and fixed housing supply, and these people just move house from time to time. Now imagine what happens if you allow all of these people to borrow a ton of money to fund their housing purchases. While this may make it easier for first time buyers, at first, over time, the price of houses will go up, and so will household debt.
Indeed, in his paper, dr. Collins shows the following graph which indicates that in advanced economies, both mortgage credit as a percentage of GDP and real house prices shot up after the reforms of the 1980s as well as after interest rates continuously dropped.
Finally, dr. Collins point out that Anglo economies like Australia, Canada, the UK, and the US were the first to implement these reforms and also the first to start experiencing excessive house price inflation, while economies like Korea and Germany, which didn’t follow this trend immediately saw falling house price during this same time period.
That being said, since this paper was written, it has become clear that household debt in some countries, like the Netherlands and the United States stopped rising and instead started to fall after the crisis of 2007, while house prices have again shot up in these countries. Something we would not expect if the mortgage explosion alone was the blame for the housing crisis.
Which suggests to me that in these countries, a construction block is the most likely explanation behind the latest rise in prices, while a mortgage explosion remains a big problem in the Australia and Canada.
However, before we finally call it a day by mentioning which of these three drivers is the most important per country, we still need to talk about the study I mentioned at the start of this video in which economists from the IMF and Bank for International settlements now claim that
houses have actually become MORE affordable
not less.
You see, if we accept that a house is for a large part an investment for which we get into debt, then it makes sense to take into account the cost of that debt. That is, if we want to know if a house is affordable these days, we have to look at its price, as well as the price of a mortgage, which is the interest rate.
And, indeed, IMF economists that looked at an average of 40 countries, did find that while, on average, house prices have gone up since the 80s, interest rates since then gone down by a lot as well.
For example, while the average mortgage rate in the US is around 7% today, it was around 19% in the 1980s.
So, could it be that actually, my video title is wrong, houses are now more affordable than ever thanks to relatively low mortgage rates?
Well, yeah, actually, when these economists combined these two effects into the affordability index you see here, they did indeed find that houses have become more affordable since the 1980s, for buyers that finance their purchase with a mortgage.
Which may sound strange. But, just to illustrate how big of a difference low interest rates make, let’s imagine that you want to buy a 100,000 Dollar studio apartment that is fully funded by a 30 year mortgage. If the interest rate is 7%, like it is today, this means that your monthly payment will be around $660 Dollars. However, if the interest rate is 19%, like it was in the 1980s, your monthly payment will now be around $1500 Dollars.
And this actually resonated with me, as, when I asked my parents, who bought a house in the late 1980s, I did find out that while they got it for a much lower price than I did a couple of years ago, their monthly costs were actually comparable to mine, given that they paid a much higher interest rate.
So, while it is tempting to just point at higher prices as evidence that houses are now less affordable, I do think that lower monthly costs are a very serious argument to consider when discussing whether or not we are in an affordability crisis.
On the other hand, focusing on average mortgage payments alone is quite controversial for three reasons. First, it implicitly assumes that everyone can just get a mortgage, which is typically not the case for the most vulnerable people in society.
Second, we should not forget that this graph here is an average of all houses in 40 countries, which means that lower house prices in advanced economies like Japan and Korea are mixed in with higher house prices in countries like Canada and Australia.
Finally, as mortgage rates have shot up in the last few years, even the mortgage based housing affordability graph shows that houses have again become much less affordable in a short amount of time, really getting some people into a lot of trouble.
Which is why I think we still need to answer the question
why you can’t afford a house anymore
using the three economic theories that we discussed namely:
- that NIMBYs are preventing house construction from keeping up with population growth, or
- that we are in another housing bubble or;
- that cheap mortgages are to blame.
But, which one of these it is, well that depends on the country that you are in. The good news is that, given that we don’t see a lot of empty homes these days, China and some Canadian cities are the only ones that likely suffer from a housing bubble.
Finally, while I do think that the mortgage explosion has big played a big role in the long-run, and is still relevant in the Netherlands and Canada, I think the evidence is strongest for NIBMY housing supply constraints being the biggest problem right now in most economies.
So, if we want to solve this crisis, I think in most countries putting measures in place to build more should be a priority. Of course, which measures these will differ per country. For example, in low density places like the US, Australia, New Zealand, and Canada, upzoning in cities will likely be the way to go, whereas in European countries like the United Kingdom and the Netherlands, the only solution might be to expand cities onto land previously reserved for nature or parks.
That being said, I do think it makes sense to introduce or keep in place anti-speculative measures, like the underused housing tax they just introduced in Canada, to prevent another bubble. And, finally, even if a mortgage explosion is no longer contributing to house price growth right now, I do think we need to have a serious conversation about whether or not we should reverse some of the lenient mortgage standards, that have contributed to permanently higher debt and house prices all around the world.
But, yeah, that is my take, what do you think? Let me know in the comments below or consider helping me make my monthly mortgage payments by supporting the channel on Patreon.