Betting the house: Monetary policy, mortgage booms and housing prices

Òscar Jordà, Moritz Schularick, Alan Taylor 18 February 2015



Although the nexus between low interest rates and the recent house price bubble remains largely unproven, observers now worry that current loose monetary conditions will stir up froth in housing markets, thus setting the stage for another painful financial crash. Central banks are struggling between the desire to awaken economic activity from its post-crisis torpor and fear of kindling the next housing bubble. The Riksbank was recently caught on the horns of this dilemma, as Svensson (2012) describes. Our new research provides the much-needed empirical backdrop to inform the debate about these trade-offs.

The recent financial crisis has led to a re-examination of the role of housing finance in the macroeconomy. It has become a top research priority to dissect the sources of house price fluctuations and their effect on household spending, mortgage borrowing, the health of financial intermediaries, and ultimately on real economic outcomes. A rapidly growing literature investigates the link between monetary policy and house prices as well as the implications of house price fluctuations for monetary policy (Del Negro and Otrok 2007, Goodhart and Hofmann 2008, Jarocinski and Smets 2008, Allen and Rogoff 2011, Glaeser, Gottlieb et al. 2010, Williams 2011, Kuttner 2012, Mian and Sufi 2014).

Despite all these references, there is relatively little empirical research about the effects of monetary policy on asset prices, especially house prices. How do monetary conditions affect mortgage borrowing and housing markets? Do low interest rates cause households to lever up on mortgages and bid up house prices, thus increasing the risk of financial crisis? And what, if anything, should central banks do about it?

Monetary conditions and house prices: 140 years of evidence

In our new paper (Jordà et al. 2014), we analyse the link between monetary conditions, mortgage credit growth, and house prices using data spanning 140 years of modern economic history across 14 advanced economies. Such a long and broad historical analysis has become possible for the first time by bringing together two novel datasets, each of which is the result of an extensive multi-year data collection effort. The first dataset covers disaggregated bank credit data, including real estate lending to households and non-financial businesses, for 17 countries (Jordà et al. 2014). The second dataset, compiled for a study by Knoll et al. (2014), presents newly unearthed data covering long-run house prices for 14 out of the 17 economies in the first dataset, from 1870 to 2012. This is the first time both datasets have been combined.

House prices, interest rates, and mortgage credit aggregates are jointly determined in equilibrium, and this makes establishing causality difficult. To finesse this problem, we exploit the well-known policy trilemma in international macroeconomics (Obstfeld and Taylor 2004). Broadly speaking, when countries peg to some base currency they effectively import the base economy’s monetary policy. Exchange rate pegs therefore provide a source of exogenous variation in domestic monetary conditions that we can use as an instrumental variable (IV) to estimate the impact of changes in monetary conditions on real estate lending and house prices.

Using the trilemma to identify exogenous interest rate changes

The trilemma provides a novel way to identify domestic interest rate perturbations that are unrelated to domestic economic conditions. Earlier research embraced this logic in a variety of ways: di Giovanni and Shambaugh (2008) use the same instrument to look at postwar output volatility in fixed and floating exchange rate regimes; Ilzetzki et al. (2013) partition countries by their exchange rate regimes to study the impact of fiscal policy shocks. In our paper, we use the IV strategy to measure the effect of exogenous fluctuations in the price of credit on mortgage and house price booms and busts.

The core assumption for the validity of the instrument is that, under full capital mobility, countries that peg their exchange rate lose control of monetary policy. Instead, monetary policy is largely imposed from abroad by the base country’s policy needs. Monetary authorities in base countries, such as the US in the Bretton Woods era, typically pay scant attention to economic conditions in foreign countries when making policy choices. Examples for this disregard are legion. At the G10 Rome meetings in 1971, US Treasury Secretary John Connally declared to the world that “the dollar is our currency, but it’s your problem”. Or, as Richard Nixon put it more colourfully, “I don’t give a shit about the lira”. Today the recurrent mutterings about currency wars tell the same story: while the spillovers from US monetary policy to the ‘dollar bloc’ of emerging economies, especially India and China, are well understood, players on all sides harbour few illusions that the Federal Reserve will shape its interest rate policies to suit conditions in far-away countries.

The trilemma instrument is certainly not a weak instrument. First stage regressions indicate that the slope coefficients are significant at the 1% level, and the regression F-statistics exceed 15 in all cases. The coefficient estimates themselves are closer to 0.5 than 1, suggesting that the pass-through from base to home rates is not one-for-one. This is not surprising since the peg is sometimes implemented using bands. The results of the first stage regression match very closely those in Obstfeld et al. (2004, 2005). The insight that the trilemma is binding has been central to open economy macroeconomics since the work of Mundell and Fleming, and in the last decade has seen extensive empirical testing and validation (Obstfeld et al. 2004, 2005, Aizenman et al. 2008, Klein and Shambaugh 2013).

Monetary policy triggers bets on the house

The central estimation problem in our paper is to evaluate how changes in monetary conditions affect mortgage borrowing and house prices. The empirical strategy combines the local projection approach (Jordà 2005) with instrumental variable methods. Recent papers that have used this particular combination of procedures include Jordà and Taylor (2013), Leduc and Wilson (2013) and Owyang et al. (2013).

Figure 1 traces the cumulative effect of an exogenous one-percentage point (100 bps) decline in the short-term interest rate (measured using three-month government debt instruments) on long-rates (measured using government bonds between five and ten years maturity), mortgage lending (measured as a ratio to GDP) and house prices (measured as a log ratio to income). Because we are using a linear model, the effect is symmetric whether we are evaluating the impact of an increase or that of a decline in the short rate.

Year zero is the year when the shock is felt. An exogenous 100 bps decrease in the short rate results in about a 50 bps decrease in the long rate on impact, and an increase in mortgage loans to GDP of about 0.5 percentage points. Yet the effect of the initial shock keeps building over time, and by year four there is about a 3 percentage point increase in the ratio of mortgage loans to GDP.

In light of the response of long-term rates and mortgage lending, one might expect house prices to increase in response to an exogenous decline in interest rates. The bottom-right panel shows that this is indeed the case. A fall of the short rate of 1 percentage point builds up over time and leads to a 4% increase of the house price-to-income ratio after four years. (Or alternatively, an exogenous increase results in a sizeable decline instead.) Various robustness checks and sample splits further strengthen our core result that monetary policy has indeed a powerful influence on households’ willingness to take bets on the house.

Figure 1. Effect of an exogenous one-percentage point reduction of the short-term interest rate on long-term rates, mortgage lending and house prices

From housing boom to bust

We have established that loose/tight monetary conditions make credit cheaper/dearer and houses more expensive/affordable. But what about the dark side of low interest rates – do they also increase the risk of a financial crash?

The answer to this question is clearly affirmative, as we show in the last part of our paper using crisis prediction models. Over the past 140 years of modern macroeconomic history, mortgage booms and house price bubbles have been associated with a higher likelihood of a financial crisis. This association is even stronger in the post-WW2 era, which was marked by the democratisation of leverage through the expansion of housing finance relative to GDP and a rapidly growing share of real estate loans as a share of banks’ balance sheets.


Our findings have important implications for the post-crisis debate about central bank policy. We provide a quantitative measure of the financial stability risks that stem from extended periods of ultra-low interest rates. We also provide a quantitative measure of the effects of monetary policy on mortgage lending and house prices. These historical insights suggest that the potentially destabilising by-products of easy money must be taken seriously and considered against the benefits of stimulating flagging economic activity. Policy, as always, must strike a fine balance between conflicting objectives.

An important implication of our study is that macroeconomic stabilisation policy has implications for financial stability, and vice versa. Resolving this dichotomy requires central banks to make greater use of macroprudential tools alongside conventional interest rate policy. One tool is insufficient to do two jobs. That is the lesson from modern macroeconomic history.


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Allen, F and K Rogoff (2011), “Asset Prices, Financial Stability and Monetary Policy”, in The Riksbank's Inquiry into the Risks in the Swedish Housing Market, Stockholm: Sveriges Riksbank, pp. 189–217.

Del Negro, M and C Otrok (2007), “99 Luftballoons: Monetary Policy and the House Price Boom across States”, Journal of Monetary Economics 54(7): 1962–85.

di Giovanni, J and J C Shambaugh (2008), “The Impact of Foreign Interest Rates on the Economy: The Role of the Exchange Rate Regime”, Journal of International Economics 74(2): 341–61.

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Jordà, Ò (2005), “Estimation and Inference of Impulse Responses by Local Projections”, American Economic Review 95(1): 161–82.

Jordà, Ò, M Schularick and A M Taylor (2013), “When Credit Bites Back”, Journal of Money, Credit and Banking 45(s2): 3–28.

Jordà, Ò, M Schularick and A M Taylor (2014), “Betting the House”, NBER Working Paper No. 20771.

Jordà, Ò and A M Taylor (2013), “The Time for Austerity: Estimating the Average Treatment Effect of Fiscal Policy”, NBER Working Paper 19414.

Klein, M W and J C Shambaugh (2013), “Rounding the Corners of the Policy Trilemma: Sources of Monetary Policy Autonomy”, NBER Working Paper 19461.

Knoll, K, M Schularick and T Steger (2014), “No Price Like Home: Global House Prices, 1870–2012”, CEPR Discussion Paper 10166.

Kuttner, K (2012), “Low Interest Rates and Housing Bubbles: Still No Smoking Gun,” Williams College, Department of Economics Working Paper 2012-01.

Leduc, S and D Wilson (2013), “Are State Government Roadblocks to Federal Stimulus? Evidence from Highway Grants in the 2009 Recovery Act”, Federal Reserve Bank of San Francisco Working Paper 2013-16.

Mian, A and A Sufi (2014), House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again, Chicago: University of Chicago Press.

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Obstfeld, M, J C Shambaugh and A M Taylor (2005), “The Trilemma in History: Tradeoffs among Exchange Rates, Monetary Policies, and Capital Mobility”, Review of Economics and Statistics 87(3): 423–38.

Obstfeld, M and A M Taylor (2004), Global Capital Markets: Integration, Crisis, and Growth, New York: Cambridge University Press.

Owyang, M T, V A Ramey and S Zubairy (2013), “Are Government Spending Multipliers Greater during Periods of Slack? Evidence from Twentieth Century Historical Data”, American Economic Review 103(3): 129–34.

Svensson, L E O (2012), “Inflation Targeting and “Leaning against the Wind”, International Journal of Forecasting 10(2): 103–14.

Williams, J C (2011), “Monetary Policy and Housing Booms”, International Journal of Central Banking 7(1): 345–55.



Topics:  Macroeconomic policy

Tags:  Mortgage booms, housing prices, monetary policy, macroprudential


Philip G. Hayward

This comment is on Jorda, Taylor and Schularick’s slightly later working paper, “Betting the House”, in which the essential subject matter is the same as the Vox article, “The Great Mortgaging”.

This commenter raised associated questions here, relating to Knoll, Schularick and Steger’s “No Price Like Home”:

I wish to comment further now on the hypothesis of the paper “Betting the House”.

There is a clear and important correlation between land markets and mortgage debt, and the volatility of the economic cycle. I have been arguing this for years; even, for example, that it is possible that the severity of the 1930’s Depression was due to this factor, and that the standard narrative based on stock markets is a red herring.

However, it is vitally important to distinguish between an urban land bubble in which rapid land price inflation is implicated, and a boom involving supply of housing on land that is low and stable in cost per square foot, and even falling in real terms.

The conclusion to “Betting the House” states:

“…The global financial crisis brought to the fore trends in housing markets that had been brewing over the decades following WW2, a break from the relative stability of the pre-WW2 era. A mixture of financial liberalization, government support, risk taking by banks, and levering up by households brought about greater rates of home ownership across the developed world. Disentangling the importance of these various forces, which surely varied by time and place, is a difficult goal for future research, and is beyond the scope of this paper. Yet the rise of leveraged real estate booms has been identified by much recent
research as being central to the understanding of financial crises…”

I agree completely that disentangling of the various forces and factors is vitally important so that our policy decisions are properly guided.

The quotations in my original comment linked to above, of Ed Glaeser on the post-WW2 era, and Nicholas Crafts on 1930’s Britain, are worth repeating here:

Ed Glaeser; “Nation of Gamblers” (2013):

“…Almost everywhere, prices in 1970 were below 1950 prices plus this construction cost related price increase. Even after the most stupendous change in America’s mortgage history, and a post-war economic boom, housing prices had gone up less than construction costs would warrant.
The natural explanation for the missing boom in prices after World War II is that there was an enormous increase in housing supply over the same time period. During the 1950s, America permitted 11.84 million housing units, which is roughly the same as America permitted during the twenty-six years from 1920 to 1945. The construction was disproportionately on the urban fringe (Jackson, 1979) and disproportionately in the Sunbelt.

The post-World War II era demonstrated exactly what textbook economics predicts should happen when robust demand meets relatively elastic supply. Quantities rose and prices stayed relatively flat. The relatively elastic supply owed much to the rise of automobile-based living on the urban fringe, which can be seen as either a shift in housing supply or a change in supply elasticity. For example, in an open-city formulation of the Alonso-Muth-Mills model, with supply costs that increase with density, lower transportation costs will increase supply but not change supply elasticity. Yet it is possible that the automobile made supply more elastic as well. On the urban fringe, lower cost, low density housing can be built in massive quantities, essentially using a constant returns-to-scale technology…

“...The missing post-war price boom is not a problem for conventional economics, but it does present a challenge to those who seek to explain bubbles as the outcomes of a stable process where readily observable exogenous variables translate into the presence of a bubble. The 1950s had easier credit for homeowners than the 1920s and economic conditions were at least as good. Any model that suggests that there is a stable relationship between either of those variables and price bubbles has difficulties with this epoch…”

“Escaping liquidity traps: Lessons from the UK’s 1930s Escape”
Nicholas Crafts 12 May 2013

Professor Crafts points out that monetary easing in the UK in the 1930′s, worked because it had somewhere productive to go:

“…….Obviously, for the cheap-money policy to work it needed to stimulate demand – a transmission mechanism into the real economy was needed. One specific aspect of this is worth exploring, namely, the impact that cheap money had on house-building. The number of houses built by the private sector rose from 133,000 in 1931/2 to 293,000 in 1934/5 and 279,000 in 1935/6 – many of these dwellings being the famous 1930s semi-detached houses which proliferated around London and more generally across southern England. The construction of these houses directly contributed an additional £55 million to economic activity by 1934 and multiplier effects from increased employment probably raised the total impact to £80 million or about a third of the increase in GDP between 1932 and 1934. House building reacted to the reduction in interest rates and also to the recognition by developers that construction costs had bottomed out; both of these stimuli resulted from the cheap-money policy (Howson 1975).

Why was house-building so responsive in the 1930s? Two factors stand out. First, the supply of mortgage finance grew rapidly and became more affordable in an economy in which there had been no financial crisis that curtailed lending.

Building society mortgage debt rose from £316 million with 720,000 borrowers in 1930 to £636 million with 1,392,000 borrowers in 1937 when about 18% of non-agricultural working-class households were buying or owned their own homes. In these years, deposits fell in some cases to 5% and repayment terms were extended from around 20 to 25 or even 30 years reducing weekly outgoings by 15% (Scott 2008).

Second, houses were affordable to an increasing number of potential buyers.
85% of new houses sold for less than £750 (£45,000 in today’s money). Terraced houses in the London area could be bought for £395 in the mid-1930s when average earnings were about £165 per year. Houses were cheap because the supply of land for housing was very elastic which in turn meant that there was no incentive for developers to sit on large land banks. Underpinning the availability of land for house-building was an almost complete absence of land-use planning restrictions which applied to only about 75,000 acres in 1932 – the draconian provisions of the 1947 Town and Country Planning Act were still to come…”

I hold that we urgently need to recognise the unprecedented effect on urban land rent, from transport system improvements and a dramatically increased potential supply of land for participants in urban economies. Automobile based development had the most dramatic effect and I would argue that the situation in 1930’s Britain included some input from this, assisting the effect of rail-based development. Of course in the USA after WW2, and indeed most other first world nations, automobile based development was without doubt the major factor. Only in Britain was this effect dampened by “the draconian provisions of the 1947 Town and Country Planning Act” as Prof. Crafts puts it.

Prior to these effects, the economic cycle was volatile as a kind of norm, and debt relating to urban land was heavily implicated in the periodic busts that occurred. Much of the political arguments about urban land rent was based on the injustice that rising productivity and incomes capitalised into higher rents for land and resource owners, leaving everybody else no further ahead. This argument was convincing enough to contribute to the tragic ascension of Marxism in several nations.

Few people today seem to understand that transport system improvements rendered Marxism irrelevant. Henry Ford was one non-specialist who saw the role of automobility in breaking both the power of the rentier class and the appeal of Marxism. But certainly Alfred Marshall possessed insights into this process, as did Robert Murray Haig, whose 1926 hypothesis on transportation and urban land rents is sound guidance for us even now, and Alonso, Wingo, Ratcliff and others carried it forward in their work as beyond controversy. We have forgotten all this because a new norm was the result, and the return of land rent inflation and volatility in urban land markets has caught us by surprise.

The conclusions of Jorda, Taylor and Schularick seem to me to miss the benign nature, in real life, of the increase in aggregate mortgage debt that was associated with rapid increases in home ownership. There were no “1930” or “2008” episodes in most first world countries and certainly not globally synchronised ones, for the decades following WW2 – the few exceptions will help us to understand the principle I am arguing here.

As I cited in my comment on Knoll, Schularick and Steger, a high price elasticity of demand for private housing space was observed in the USA following WW2 (ref Goldberg 1970). I would like to hypothesise in more depth about this here.

As economies develop and the cost of most consumption items fall in real terms, and the cost per square foot of private living space also falls in real terms, people previously constrained in this consumption of space will even increase their spending on housing as a proportion of income, as they can consume space and other attributes of housing in which there is now consumer surplus. Of course once upon a time people spent 50% of their incomes on food. More housing space is a perfectly logical item on which to spend the windfall as the real cost of food and other necessities falls. People don’t increase the share of their incomes spent on food as the real cost of it falls (perhaps because it falls so much); but they will do so for housing space.

Of course many of the people moving into homes for which there is newly created mortgage debt, as the economy develops, are moving from rural residences that have been unencumbered with debt long since, often passed down the generations in the same rural family; as well as former urban renters becoming home owners for the first time – in which latter case mortgage repayments are a substitute for rental payments, not an all-new burden increasing systemic risk.

Even “house prices” can be observed rising as the cost of urban land per square foot plummets. Any useful analysis of this whole issue needs to identify the trend in the cost of urban land per square foot, which will generally be quite dramatic in itself, only concealed in “house prices” by a rebound in consumption of space - and house size and quality - as it is falling; and in the opposite case, as it is rising, it is partially concealed by reduced consumption of space, crowding, and “pricing out” of households eg into informal housing or co-habitation with parents or other family (not to mention household formation foregone altogether, with consequences for social stability). The cost of the actual structures becomes more or less significant in the overall “house price” as the case may be.

I hold that the periods of rising mortgage debt associated with very healthy construction of new housing and increases in home ownership, as real land costs fell, were largely beneficial to the economies (and indeed the societies) involved. The flow-on multiplier effects from the actual construction of housing are considerable, in contrast to the zero-sum transfers of wealth to rentiers that is associated with rising land prices. I hold that the severity of the bust in the economic cycle will correlate almost entirely to the increase in debt that was associated with this zero-sum land price inflation. I believe that this hypothesis will hold good for Ireland and Spain’s recent episodes, and also the role in the “US” housing bubble of land value inflation in California and a few other regions. The many stable-price markets in the USA is undeniable evidence that urban land market distortions from various regulations of supply of land, are a causative factor in the return of the “urban land driven” bubble and bust.

Another worthwhile data test case would be the earlier, 1980’s episode in California and Texas and the way it differed in these two locations. Texas seems to be the better-remembered case for some odd reason; its prices actually did not fluctuate greatly (median multiples remained at three-point-something), and the overbuilding of housing was rapidly filled following the bust, by in-migration and new household formation. By the 2000’s episode, Texas was virtually immune to the bubble and bust effects that have decimated California. And the 1980’s episode has not gone down in history as a “US housing bubble”.

Understanding the role of land prices per square foot and their direction of movement, will lead us to dismiss the relevance of all-country aggregate data, and lessen the importance of monetary looseness.

It is also not helpful to view “since WW2” as one uniform period – the systemic change in urban land markets, to rising rents/prices of urban land per square foot, is correlated entirely with the materialisation of policies and regulations that prevent the continued conversion of low-cost rural land to housing development that marked the post-WW2 era in most countries. It is very obvious in almost all countries now, that the price of land on which urban development is allowed, has inflated considerably, often by a factor of some tens of times within a single decade, and the average size of lots has fallen in a partial attempt to compensate which nonetheless has completely failed to stabilise “house prices”. It is entirely typical that new fringe family housing in Australia, Canada and other countries has doubled or more than doubled in price even as the lot sizes have fallen by around 50%, even as construction cost contributions have remained stable. Furthermore, depreciated housing in more mature locations tends to have more than doubled in price; sometimes the price inflation is as much as a factor of 10. This phenomenon, a dramatic reversal of decades of a new norm, correlates undeniably with the recent fashion for “compact city” and “anti-sprawl” and “transit oriented” planning. This recent era absolutely must not be confused and conflated with the post-WW2 decades immediately preceding it in most first world countries.

Britain is a notable exception that proves the rule, in that due to its 1947 Town and Country Planning Act, its average consumption of space per household from that point never remotely tracked even that of France or Germany, let alone Australia and New Zealand, let alone the USA.

Expecting monetary policy to be able to cope with these distortions is unrealistic and only creates more and more unintended consequences elsewhere. For example, tight credit will harm productive investment. A 2010 OECD report, “A Bird’s Eye View of OECD Housing Markets” said the following:

“……Another concern is about the ability of monetary policy to thwart the development of a housing bubble without causing widespread damage to the rest of the economy. In a house price boom, prices increase strongly – often at double digit rates – and expectations of future prices are similarly upbeat.
Under these conditions, large policy rate hikes would be necessary to cool housing markets. High interest rates would crowd out sound and socially useful investments….”

Regarding macroprudential policies: they probably render the finance system less vulnerable, but I have argued for years that the elasticity of supply of housing determines what proportion of people will be priced out of the market; all the other factors merely determine at what level of prices, savings, and debt, the supply of living space is allocated to the lucky winners.

The Bank of International Settlements recent paper is confirming:

“Can Non-interest Rate Policies Stabilise Housing Markets? Evidence from a Panel of 57 Economies”

- Conclusion:

“...None of the policies designed to affect either the supply of or the demand for credit has a discernible impact on house prices. This has implications for the degree to which credit-constrained households are the marginal purchasers of housing, or for the importance of housing supply, which is not explicitly considered in this Study…”

They also say that even LVR (loan to value ratio) restrictions have no discernible effect on either house prices or mortgage credit expansion. I had long understood this to be the case, based on South Korean housing market history. The only constraint on credit that has any effect on credit expansion, is restrictions on the proportion of borrower's incomes that repayments may exceed. This still does not affect house prices.

This is because the other variable that can expand to take up the slack in restrictions on borrowing, is home buyers ability to save. Paying back more money later is merely replaced by saving more money earlier, with the lucky winners in the gladiatorial bidding war for space merely having to save for a bit longer. Interestingly, even in South Korea with very restrictive LVR policies and persistence of very substantial aggregate “savings in progress” by aspirational home buyers, the amount of mortgage debt taken on has still been sufficient to destabilise the finance system.

There are many flow-on negatives from increased economic rent per square foot of urban land and private living space. I hold that not least among these effects, is that it reduces real production/aggregate demand. I recommend my own work, Philip G. Hayward (2013) “The Power and Necessity of Consumer Surplus”.

There is now a rich literature analysing the effects of several decades of growth containment planning in Britain, for example from Alan W. Evans and various colleagues, and from LSE professors such as Paul Cheshire and various colleagues. It is difficult today to find another reason for the UK economy’s productivity gap, which is completely contrary to the assumptions of modern planning advocates that arbitrarily containing the spatial spread of a city will increase its productivity. This assumption is essentially cargo-cultism: there are some observable correlations between density and productivity, therefore forcing a city to be denser will make it more productive – just as aeroplanes carrying the goods of modern civilisation (down from the gods) are believed by some primitive tribespeople to be the cause of the wealth of modern civilisation.

This author’s submission to an Inquiry by the NZ Productivity Commission covers many of the factors by which growth containment urban planning reduces productivity:

There are also serious implications for social justice, which is allegedly a significant political concern in our times.

Capital is not back: A comment on Thomas Piketty’s ‘Capital in the 21st Century’
Odran Bonnet, Pierre-Henri Bono, Guillaume Camille Chapelle, Étienne Wasmer 30 June 2014

Thomas Piketty’s claim that the ratio of capital to national income is approaching 19th-century levels has fuelled the debate over inequality. This column argues that Piketty’s claim rests on the recent increase in the price of housing. Other forms of capital are, relative to income, at much lower levels than they were a century ago.

Matt Ridley instinctively also got this right in a June 2013 column in the Times of London:

“…..Well, knock me down with a feather. You mean to say that during three decades when the government encouraged asset bubbles in house prices; gave tax breaks to pensions; lightly taxed wealthy non-doms; and severely restricted the supply of land for housing, pushing up the premium earned by planning permission for development, the wealthy owners of capital saw their relative wealth increase slightly? Well, I’ll be…….

“……..Neither Britain nor the world is especially unequal right now compared with most of the past two centuries. If you want to reduce wealth inequality in Britain, then the quickest way is to liberalise the planning laws to bring down house prices……”

I am pleased to see that Joseph Stiglitz is now among those who see this reality:

Thomas Piketty gets income inequality wrong
Joseph Stiglitz Jan 2, 2015

It is now well established that the connection between lower incomes and poorer child health outcomes, is the quality of housing into which lower income households are “priced out”. It is observable that housing in markets where urban land rent is rising, is renewed more slowly and even repairs, maintenance and modernisations are reduced by lack of discretionary household income. John Stewart (2002) estimated that houses in Britain will be required to last 1400 years on average under the current rate of building and renewal.

It needs to be understood that because mortgage interest rates generally correlate with inflation and hence nominal income growth, it hardly matters what the inflation rate and interest rate is, it can literally be stated as a kind of general rule:

o House price multiple 3: total share of 25 years income required to pay off a house: 10 percent
o House price multiple 6: total share of 25 years income required to pay off a house: 30 percent
o House price multiple 8: total share of 25 years income required to pay off a house: 40 percent

But this is not all – with a lower initial interest rate combined with a large mortgage principal, the chances of an interest rate increase that is immediately catastrophic for the household budget, is much higher. In fact households are left far more vulnerable to financial reversal of any kind during a much longer period; sickness or injury of either breadwinner; or of one of their children; a child with a disability; loss of employment; a natural disaster; being the victim of a crime; breakup of marriage; unpredicted costly home repairs; the need to care for an elderly relation; an increase in interest rates – a whole host of scenarios that tend to affect a certain proportion of the population during their lifetimes – will tip a much higher proportion of households into bankruptcy during that lifetime. Professor – now US Senator – Elizabeth Warren calls this “The Coming Collapse of the Middle Class”, in videoed presentations that made her a celebrity. It is not apparent, however, that she understands the causes of this phenomenon in our current time or what the correct solutions are.

Prof. Robert Bruegmann, a true urban expert, uses the term “the greatest intergenerational wealth transfer in history” to describe these outcomes, and puts the blame where it belongs – on the regulatory distortions to the supply of land for housing.

The advocates of the growth containment policies will insist that these are non-negotiable due to an existential crisis confronting humanity concerning resource consumption and carbon emissions. This is an absurd excuse given the far greater appropriateness of fiscal incentives targeted directly at resources and emissions. Anthony Downs in “Still Stuck in Traffic” (2004) comments that the preference for urban planning measures, is like addressing the position of a picture on a living-room wall by moving the wall rather than the picture.

A more lengthy discussion worth quoting, is Alan W. Evans (1998) “Dr. Pangloss Finds His Profession: Sustainability, Transport, and Land Use Planning in Britain”:

“In this paper, I look at the use of land use planning to promote global sustainability by reducing the use of fossil fuels in transport. The first theme of the paper is that land use planning is an inefficient instrument for this purpose and may actually increase the use of fuel. The second theme relates to land use planning in Britain, where sustainability has been seized on as a justification for existing policies of urban containment. I argue that some of these policies, in particular the designation of greenbelts, actually increase car use and the length of journeys.”

From the Conclusion:

“…Land use planning is necessary to deal with the externalities, particularly the external diseconomies endemic in urban life. These externalities may be physical—the notorious smoking Factory chimney—or aesthetic—the desire to preserve open space and the visual environment. These are legitimate concerns of land use planning. But these externalities are spatial in that they are the costs imposed on one group residing or employment in a city by another group. The allocation of land uses seems to be one obvious way in which they can be controlled. But the concept of sustainability arises out of the idea that the consumption of a good by one group will have an impact not on nearby residents, or even on those currently living, but on those yet to be born anywhere in the world. It is the antithesis of the kind of spatial externality for which land use controls were designed, and can clearly best be dealt with by the taxation or other regulation of the fuel and other exhaustible resources that need to be conserved. The policies may, in practice, lead to longer journeys rather than shorter and to a greater use of fuel than would have occurred otherwise. Thus the policies may serve both to restrict economic growth on the grounds of global sustainability, and to increase fuel consumption, thus achieving the worst of all possible worlds rather than the best.”

I would add to this that there is at the very least an appearance of vested rentier interests in these misguided urban policy preferences.

There are two problems that advocates of certain perennial favourite Statist housing solutions need to grasp.

1) Under conditions of growth containment land supply rationing, upzoning increases site rents, it does not reduce economic rents per dwelling. If anything, the correlation in data sets of cities, runs in the direction that the denser they are, the higher their housing price median multiple is – with cities of 800 people per square km at the median multiple 3 end of the scale and cities of 23,000 people per square km at the median multiple 15 end of the scale. Obviously site rent is much more elastic than the floor-space-supply response.

2) Under conditions of growth containment, provision of “social housing” will leave the cohort of society that does not qualify for it, worse off than those that do. By 1974 fully 1/3 of British were in “social housing” and as PM Margaret Thatcher put it, this was one of many areas of government expenditure that was “running out of other people’s money”. But the next 10%+ of society that did not qualify for social housing, was largely worse off than those who did. It has often been commented by conservative policy advocates that the cost of paying one’s own way in the UK housing market, on coming off welfare, earning an income, and losing one’s “social housing” is like a tax at the margins of well over 100%. This outcome would continue to apply as the proportion of people in social housing continued to rise, even if this was 50% or higher (presumably temporarily sustained by ultimately unsustainable increases in public and national debt).

Research Advisor, Federal Reserve Bank of San Francisco; Professor of Economics, UC Davis

Professor of Economics, University of Bonn and CEPR Research Fellow

Professor of Economics and Finance, University of California, Davis; Research Fellow, CEPR

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