Curbing finance might make housing cheaper, but would it make us better off?

by Brendan Coates

Published by Inside Story, Monday 11 February

Despite recent falls in house prices, many younger Australians remain justifiably anxious about housing affordability. Prices have risen far faster than incomes, fewer younger Australians expect to own a home in their lifetimes, and more are suffering rental stress. Similar patterns are playing out across much of the Western world. In Why You Can’t Afford a Home, British economist Josh Ryan-Collins pins the blame on the banks — sound familiar? — arguing that the combination of unlimited loan funds and scarce land have pushed up house prices, reduced home ownership, and increased inequality and debt.

Ryan-Collins demonstrates that neoclassical economics has a blind spot when it comes to land. Unlike Adam Smith, Henry George and other early economists, most modern economic theory ignores the distinct features of land: we can’t make more of it, and it doesn’t depreciate. Instead, land is treated like any other form of capital, and the windfall gains that naturally accrue to landowners in a growing economy — generally referred to as “land rents” — have been allowed to grow.

Ryan-Collins also points out that the way most economics textbooks treat banks — as institutions taking the money of savers and lending it to willing borrowers — bears little resemblance to reality. Money is actually createdwhen banks make loans — a point made recently by both the Bank of England and our own Reserve Bank. And so the real limit on credit is not savings but banks’ willingness to make loans (subject to the whims of regulators).

These two factors meant that the deregulation of banks in Australia and elsewhere led to an explosion in household debt that was channelled overwhelmingly into housing. The expanding credit created a bidding war, driving up land values, and those higher prices led to more demand for mortgage credit, which further pumped up land prices, and so on.

The Australian experience bears out much of Ryan-Collins’s thesis. Australia’s ratio of household debt to GDP has rocketed, from 70 per cent in the early 1990s to more than 190 per cent today. And house prices have followed suit — more than doubling in real terms over the past twenty years, mostly reflecting rising land values.

Many of Ryan-Collins’ policy prescriptions to tame housing markets echo those made by Grattan Institute in recent years: higher recurrent taxes on landmore secure rental tenancies, scaling back the favourable treatment of housing provided by negative gearing and the capital gains discount, and including the family home in the age pension assets test.

But Ryan-Collins also pushes a more radical idea: a return to the Keynesian “golden period” where most countries adopted “credit guidance” — essentially controls on credit for mortgages. He cites approvingly the examples of Germany, Austria, South Korea, Japan and Singapore, where household debt has grown slowly and house prices have fallen relative to incomes since the 1990s.

There’s little doubt restricting credit further would reduce house prices. With Australian banks clamping down on lending in response to the Hayne royal commission and tighter macro-prudential rules, and new housing construction reaching record levels, prices here have gone into reverse. And lower household debt reduces the risk of our banks getting into trouble, with all the economic chaos that would create.

But the book doesn’t engage seriously with the arguments for liberalising mortgage markets in the first place, and the costs of turning back.

Deregulating the banks meant that those who were not wealthy or well-connected could also obtain finance to purchase a home. Homebuyers were no longer restricted to borrowing only two or three times the value of their annual income. Greater access to credit may have bid up land values, but it’s also a big reason why most of us are better housed in larger and better-appointed homes than we have been in the past, even if we’re now paying more for the privilege.

Reining in mortgage credit would not make housing more affordable for everyone: people who could still obtain a mortgage would be winners because housing would be cheaper to buy; people who couldn’t get a loan would be the losers. And tighter credit controls could also raise the costs of credit, boosting banks’ profits at the expense of borrowers. The Productivity Commission found that recent macro-prudential rules restricting growth in investor and interest-only lending led to higher interest rates, boosting bank profits by $1 billion.

Such costs may be justified in an effort to secure more affordable housing. But Ryan-Collins’s argument would be much stronger if he’d addressed the potential downsides to his proposals.

And one wonders whether his objective of more affordable housing could be achieved without such collateral damage. Higher taxes on land could bring down house prices without constraining our ability to finance the construction of more and better housing or hurting the economy.

But most importantly, his book neglects the potential for planning rules to boost housing supply, reducing rents and house prices. After all, while land may be scarce, housing doesn’t have to be if we’re willing to build denser cities. Instead of increased mortgage debt fuelling higher house prices, it could lead to more home-building instead.

A recent study by the Reserve Bank of Australia estimated that land-use planning rules restricting what can be built, and where, added as much as $489,000 to the cost of the average house in Sydney. Other studies in the United States and New Zealand have found that restrictive planning rules inflate house prices.

Of course, land use planning rules benefit other land users by preserving the amenity of existing residents or preventing increased congestion. But studies assessing the local costs and benefits of current rules generally conclude that the negative externalities are much smaller than the costs of regulation.

Recent Grattan Institute research shows that relaxing planning rules to allow more homes to be built close the centres of major cities where people want to live would make housing more affordable. Today’s record level of housing construction in Australia is the bare minimum needed to meet record levels of population growth driven by migration.

Past episodes of rising housing demand did not see such rapid increases in house prices. Rapid population growth in Australia in the 1950s was matched by record rates of home building. House prices barely moved. Similarly, the postwar expansion of mortgage credit in the United States led to more houses but not higher house prices. Perhaps the same would hold true today.

It’s no coincidence that many of the countries with the biggest declines in house prices in the past two decades, such as Japan, have also built the most new housing.

Why You Can’t Afford a Home is a powerful call to arms to younger generations worried about worsening housing affordability. Ryan-Collins is right that radical change is needed to make housing more affordable: higher taxes on land, more secure tenancies and less favourable tax treatment of housing would all make a difference. But policymakers should be cautious about adopting all of his policy prescriptions without considering their costs, and should remember that they will also need to set planning rules to allow enough new building for a growing population.