Our House Price Economy

The US stock market is taking a breather to start 2014. Company earnings aren’t coming out as rosy as expected. Which is a surprise, even though it almost always happens.

This chart shows how reported earnings (blue dots) end up below the green lines, which track expectations over time.


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The exceptions were in 2005 and 2006, before all hell broke loose in the financial system. In other words, if things are running suspiciously well, it’s time to be suspicious.

Sure enough, even with disappointing profits relative to expectations, profits themselves are still ridiculously high. Chris Brightman from Research Affiliates took a closer look at just how exuberant things are.

‘Profits are dangerously elevated by all reasonable measures. S&P 500 Index real earnings per share are far above their long-term historical trend. Industry profit margins are at or near all-time highs. Corporate profits, both as a percentage of GDP and relative to labor income, are at or near record levels. The dramatic rise in income inequality is a direct consequence of this spectacular reallocation of income to capital and away from labor.

The good news is that this is likely to reverse in coming years. The profitability boom is on borrowed time. That’s because its source is a lack of reinvestment. Companies aren’t using their cash to invest in future profits and growth. They’re letting it all flow to profits instead and then holding onto the cash or returning it to shareholders. But eventually that lack of reinvestment will hit the bottom line.

The bad news is that when profits do take a hit from a lack of reinvestment, labour won’t be getting its due. There won’t be enough demand for workers after a period of underinvestment. Instead, both labour and capital will suffer, because companies will need to raise new cash from investors if they want to expand. In other words, companies have shot both themselves and their workers in the foot in one go by failing to invest in future growth.

None of this matters to Australia, of course. Our economy is completely different. Real estate agents suspended the laws of economics here long ago. Stuff the stock market, companies and investing in productive businesses and assets. Our economy is built on rising house prices, which make us all richer. And there is ‘No end in sight for house price rises‘ according to the Australian Financial Review.Whoo hoo! Endless prosperity as far as the homeowner can see.

But data gathering firms Australian Property Monitors and RP Data have both issued warnings that this froth can’t go on. Rents are flatlining while prices surge. Good old negative gearing comes to the rescue, of course. Although that could end up a curse instead of a blessing. If the job market struggles, losing money on an investment property will be very expensive for those on the property ladder.

Never mind where house prices are at, or where they’re going. It’s impossible to predict how irrational home buyers want to get before reality hits. As we’ve been trying to explain in the latest issue of The Money for Life Letter, price and value are two very different things. The first is a matter of supply and demand. And oh boy can those two misbehave.

So what is the value of a house? Because, eventually, price will return to that point. Well houses are pretty darn hard to value. Is it a question of rental yields? Or are houses a consumption item like food? Shelter is one of the necessities of life. It’s a requirement before we can go on to earning a living. So maybe house values are determined by the living they allow us to earn – price to income ratios.

It doesn’t really matter how you do it. On just about every measure you can come up with, house prices are too high. The 2014 Demographia housing survey is out. And once again, Australia comes in a ‘severely unaffordable’.

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Source: Demographia

But what’s becoming more interesting is a different angle. Let’s take a step back and look at things from a ‘macro’ level. What is the value of high house prices to the economy as a whole? Does it make us better off to have higher house prices? Is the national obsession of house price speculation a good one?

It certainly makes banks and their shareholders wealthy. Every dollar prices increase is another dollar borrowed. And every dollar borrowed shows up as an asset and income on the bank’s books. It’s a liability and expense for the borrower though. So why on earth cheer house price increases?

If you think that the homeowner is getting richer as house prices rise, you’re wrong. They still need a house to live in. And so if they want to sell the house that went up in price, they have to buy another one that also went up in price. In real terms, they’re no better off.

Sure, selling in overpriced neighbourhoods and buying in underpriced ones might be a recipe for success. It is with any asset though. But that’s not how the property ladder is sold to potential borrowers. And selling out to become a renter is just unpatriotic.

–So in the end, home owners are not getting richer at the expense of the rest of us. Only the banks and super funds benefit. That’s quite an achievement. But it isn’t much of a formula for economic success. That would involve making or providing something of value.

So what about construction then? Does house construction add value to our lives? Well, it increases the supply of housing. And that’s positively dangerous for the health of an economy which is built on rising house prices. Increasing supply would reduce prices. We can’t have that.

What has us totally baffled is that, in the midst of all this, it’s still the same house that’s going up in value. Why would a consumption good that depreciates with time go up in value? Other consumption goods go down in value over time.

All the reasons trotted out in reply don’t seem to apply to anything else you own. Only houses. House prices in parts of the Netherlands, which has some of the oldest records that exist, haven’t gone up in real terms for centuries.

Oh, we forgot, Australia is different. That’s the Aussie version of the ‘this time is different’ argument. But how is Australia different? The answer is politics, says Saul Eslake, chief economist of Bank of America Merrill Lynch. He explained that growth in housing supply has been slower than the growth in population in the past 10 years – for the first time in more than 50 years. And first home buyer grants and negative gearing only made the supply and demand imbalance worse.

Anyway, the real problem is that the nation as a whole doesn’t get anything out of rising house prices in the first place. It’s not like the stock market where prices influence the ability of companies to raise money to invest. The price you pay for a house is dead money once it’s spent. Except to the bank.

The fact that Australians hate banks but love property is an amusing paradox. Every time banks announce their record profits, Australians do the national equivalent of rioting in the streets – they take to blogs and post comments using pseudonyms.

But who is paying the banks those profits in the first place? And who are the banks paying those profits to? It’s the same people doing the complaining, and those people’s Super funds. It’s not like they were forced to borrow the money. (But they were, in effect, forced to invest in bank shares.)

Of course, the funniest part is that Australians would be toast if they wanted to stop the banks from making ridiculous profits. They’d have to stop borrowing money, signalling a tumble in house prices. And the value of their super fund’s shares would tank too. So be careful what you wish for.

For now, all’s well in our negatively geared economy. Even the government wants to get in on the banking rort. Proposals to increase the fee banks pay for government deposit guarantees are in the works. The argument is that financial companies who can’t get the government guarantee are at a disadvantage to the banks who are deemed to be ‘safer’ because they have government backing. Charging the banks more will make things fair.

This makes no sense if you bother to think it through. Increasing the cost of a deposit guarantee doesn’t change how competitive the product offerings are to customers. The same problem remains. One company’s services are government guaranteed, the other’s aren’t.

In the end, this is just another tax.


Nick Hubble+
for Markets and Money


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Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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