Is it all “Supply & Demand”?

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As we head towards the federal election, the term ‘housing shortage’ will be trotted out again and again by politicians. Their rhetoric will rely on the deeply ingrained received wisdom that Australia has a ‘housing shortage’, and no politician will want to do the hard work of differentiating between a genuine shortage in housing stock (which we don’t have) and a shortage of ‘affordable housing’ which we do have.

And why won’t they acknowledge this distinction? Simply, because admitting that it is only the prices of houses that are dysfunctional, and not simply the supply, would be too much even for their loyal voters.

Once groupthink has infected politicians and media commentators, reason goes out the door. That’s why I find it infuriating to hear constant reference to Australia’s soaring prices being simply a product of a ‘supply and demand’ imbalance.

The supply-demand argument is easy to sell. The reasoning goes that there are too few houses being built, and the housing market is just like any ordinary commodity market, so the price rises.

This pricing model is superficially appealing at the level of everyday consumer items – corkflakes, for instance (though even here it’s a flawed logic, as I explain in these two [1] [2] rather technical papers). But the model breaks down completely in asset markets. If the price of corkflakes rises due to supply constraints, consumers switch to complementary goods. They don’t rush to the supermarket to buy more cornflakes at the higher price.

But in asset markets, consumer behaviour is turned on its head. Instead of being more reluctant to buy an asset that is rising in price, buyers reason that they’d better get in quick and buy while the asset is still within their reach. So higher prices actually stimulate demand, and this behavior often reaches a fever pitch a short time before an asset bubble deflates.

In other words, prices have a perverse impact upon asset markets, and it is simplistic to interpret how asset prices behave simply on the basis of “supply and demand” analysis.

It’s also rather hard to sustain the “supply and demand” argument on the basis of the data alone—because it if were true, house prices should have been falling (relative to the price of other goods) for most of the last thirty years.

Firstly it’s obvious that real house prices have been rising in real terms. The next chart deflates the ABS’s index for established houses (ABS 641601 and 641603) by the CPI. Houses are now two and a half times as expensive—relative to other goods—as they were in 1986.

And yet for most of that period, we’ve been building accommodation at a faster rate than population has been growing—so on “supply and demand” logic, house prices should have been falling for all but the last couple of years.

Have a look at the chart below. The average number of people living in each dwelling in Australia in the year 2007 was around 2.6 (the black line)—and it was higher in earlier years. To keep the ratio of people to dwellings constant, we would need to build a new dwelling for every 2.6 new people. In fact, on average between 1986 and 2009, we’ve been building a new dwelling for every 1.8 new Australian residents. Only in the last couple of years—after the GFC hit—has population grown more rapidly than we’ve added accommodation.

This is where neo-classical economists’ ‘supply-demand’ arguments fail the common-sense test. If we’ve consistently built more new dwellings than required by the number of new people in Australia, and if “supply and demand” explained everything, then real prices should have been falling for all but the last couple of years (in the past two years a new dwelling has been built for approximately every 3 new people – see chart).

News last week that Sydney has just recorded a six-year high in building approvals (http://www.smh.com.au/business/property/big-surge-in-number-of-new-homes-approved-20100505-uas8.html) will be welcomed by politicians and commentators wanting to argue that the ‘shortage’ is being addressed.

But if ‘supply and demand’ cannot explain the rise in house prices over the past quarter century, then this additional supply—when it comes online—may have an equally perverse impact: it might accelerate a downturn caused by the end of the great expansion in household debt that has been the real force driving house prices up. The new spike in approvals may actually create an oversupply after the great inflation caused by rising debt has already ended.

We need to bury the ‘housing shortage’ myth, but to do so requires a shift in thinking. Economists follow a model of the economy that is as realistic as the view that the Earth is the centre of the universe, and the Sun, Moon and planets revolve around it. It took the GFC to expose just how unrealistic this model is—a model that ignores credit and pretends that everything happens in equilibrium. We instead live in a credit-driven world which is always in disequilibrium. Until economists and policy makers recognize this, we are likely to have policies that address symptoms but not causes, and ultimately make the problem worse rather than better.

If we are to address the real causes of the GFC, then policy makers have to confront the problem of an out of control credit system that drove mortgage debt up by a factor of five and turned the Australian housing market into the world’s last surviving Ponzi Scheme.

Then again, it is most likely too late – the current frenzy of house buying and house price growth is completely decoupled from any sense of scarcity in the market, and has all the signs of a balloon about to burst.

 

 

 

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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130 Responses to Is it all “Supply & Demand”?

  1. MMitchell says:

    Philip,

    Sorry again. One more thing. If you are interested in Sociocracy a reference is:

    Buck, J. and Villines, S. 2007. We The People: Consenting to a Deeper Democracy, a Guide to Sociocratic principles and Methods. Sociocracy.info, Washington D.C.

  2. MMitchell says:

    Philip #124,

    There is an easy solution to this problem you raise. Simply legislate that all companies above a certain size need to be run using sociocratic principles. This is one effective way to limit the size of our current pathological corporate structure and legal framework while still allowing for large projects.

  3. Philip says:

    MMitchell,

    Yes, in theory that could work. Unfortunately, capitalists are greatly opposed to workplace democracy and decentralization. For a country such as Australia to call itself democratic is a joke considering that such democracy is limited to selecting representatives of one institution in our society while the workplace – where we spend half our waking hours – is run under conditions of authoritarianism.

    If any such legislation were forced upon the state-corporate nexus, it would have to be on the backs of a strong progressive working class movement.

  4. pb says:

    bb
    If Australia truly becomes a place where only the rich can afford housing then we will truly start looking like the following countries.

    Morocco 67.5
    Pakistan 40.63
    Belarus 40.0
    Montenegro 30.0
    Russia 28.58
    Romania 24.28
    Lithuania 20.84
    Serbia 18.8
    Latvia 18.33
    Ukraine 17.37

    Surely then we can stop looking for Australia in those charts like “Top countries to live” , “Top free countries for Business”

  5. MMitchell says:

    Philip,

    “Unfortunately, capitalists are greatly opposed to workplace democracy and decentralization.”

    Yes, well one could imagine that such a change would lead to a huge loss of wealth for many. However, IMHO the current economic system will not survive much longer anyway leading to massive wealth losses and much more. This way we still get a massive wealth loss but also the opportunity to take something bad and make something good of it rather than letting it all deteriorate into chaos. Like you say though, Buckley’s Chances.

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