Anatomy of a House Price Boom
If I have managed to communicate anything at all worthwhile in previous blog posts, I would like it to be the idea that any person with normally functioning intellectual faculties can learn how to understand economic phenomena if they exercise a bit of mental discipline. This is because economics is not, when properly practiced, the manipulation of vague and abstract concepts operating outside the realm of ordinary logic. Nor does it consist of complicated mathematical calculation and the construction of ever more elaborate models. Instead, it is simply the practice of thinking logically, step by step, about generic human action within the context of society. Once you learn how to do this, you will find it both a revelation, since so much that has been obscure to billions will suddenly seem utterly comprehensible, and, deeply disappointing, since you will find out that there is no magic answer that can solve all our ills, nor even make you personally rich. Furthermore, you will be constantly be fuming about the idiocy of those, most notably politicians and journalists, who prefer to fall back on meaningless platitudes, lazy prejudice or the shamanic utterances of tenured academics rather than ever sit down and think about whether what they are saying makes any sense whatsoever.
Anyway, with that mission statement out the way, we can get down to a practical example, how a house price boom, such as occurred in much of the Anglo-Saxon world over the three decades before the crash, can happen. We will work, step by step, starting at the following imaginary situation.
1) A free market economy: In this scenario every individual in society can only earn a living either by providing his fellows with some good or service they require or, if circumstances preclude him from doing so, asking for their charity. Such a society is, of course, a rather utopian picture; not in the same sense that socialism is, namely that it is literally impossible for it work, but simply because, for it to emerge, a great moral reformation on the part of mankind is required and we have no reason to expect that to happen.
Be that as is may, what would the housing market look like in such a society? The answer is simple: since shelter is a desirable good for more or less most people, many people will, at any given time, be buying houses, flats, bungalows, palaces or what have you from people who own them. Other people who cannot afford to buy one of these, or for whom it is not convenient, will instead choose to rent. Many people will save up over years or decades in order to buy a home they cannot presently afford; those who invest their savings wisely in profitable investments that benefit the general public will be able to cut down this waiting period significantly. Some minority of people who cannot afford a house will nevertheless choose to buy one with money they obtain through a loan. Of course, they will have to pay compound interest on this loan, so the house which they buy for £100,000, will actually end up costing them, say, £200,000. If we estimate that the rent they would have paid over the period would have come to £25,000, they have chosen to forgo £75,000. The reason they take this choice is that the present joy they derive from owning this house is worth more to them than the £75,000 worth of enjoyment they lose in the future. Another way of looking at it is that the time that they spend living in this house rather than rented accommodation in the interim period between when they actually bought the house and when they would have been able to buy it without the loan is worth £75,000 to them in their own subjective valuation.
2) Enter the banks: In a free market economy when all loans have to be financed by prior saving people will find it very hard to get a loan to buy a house, after all, they are competing for limited funds with businessman who actually hope to earn a profit on what they are going to borrow and hence can afford higher interest payments. But it all becomes very different when we imagine a scenario that includes fractional-reserve banking. In such a society banks produce un-backed money substitutes by loaning out money whilst also allowing depositors to withdraw it on demand. In so doing, they are able to expand the supply of “money” by a factor of more than ten simply by creating loans out of thin air that they can then charge interest on. In the kind of society we are looking at, such as our own, instead of prosecuting these banks for fraud, the government protects their activities and even creates a whole legal and financial infrastructure to allow banks to practise without fear of bankruptcy; bankers become some of the most wealthy and powerful people in society.
What happens to the housing market in this situation? Well, since banks can now create loans out of thin air, they can also make much more of them and charge lower interest rates. A much greater proportion of the population now chooses to buy now with a loan rather than later by saving, since the money they are losing by taking that choice is much lower.
3) Prices go up: However, as we said, when fractional reserve banks make loans they do so by creating un-backed money substitutes that, unless there is a bank run, function just like money. If lots of people are using this new “money” to buy homes, this means demand, in monetary terms, has gone up, which in turn will mean the prices of homes go up. After a few years of house price inflation, many people will realise that it makes much more sense to buy now rather than later. After all, the house now may cost £100,000 and they will end up paying £150,000 if they take a loan, BUT if they wait they will have to pay £150,000 for it anyway because the price will have gone up. Essentially, it now costs you nothing to buy now rather than defer your enjoyment till later. Saving has become a stupid choice, not a prudent one, and deferred gratification is not the mark of a mature person, but a sucker. Accordingly, even more people will choose to buy their house with a loan until eventually it becomes normal and more loans means even higher prices.
4) Reality is turned on its head: After a few more years of this, with prices rising faster and faster, some canny people start to realise something. If they buy a house now for £100,000, they will end up paying £150,000 down the line, but by that point the house will not only be worth that, it might be worth double that much, may even triple! You can actually make money, just by buying a house you can’t afford with a loan and then living in it for a decade! In a free-market society, people save money in order to buy homes, in an economy distorted by bank chicanery, people buy homes in order to have money!
But it gets even better than that! If you buy a home for £100,000 and it doubles in value, then you’ll make a lot of money, if you buy a home for £1,000,000 and it doubles in value, you’ll make enough never to work a day in your life again! The more you can’t afford the house you’re buying, the better business decision it is to buy it. And, if you can’t afford the loan repayments, big deal! You can get a deferred payment plan and pay them off comfortably when you sell the house.
Meanwhile landlords have to charge higher and higher rents, putting decent accommodation out of the reach of people who, for whatever reason, haven’t joined the ‘housing ladder’ yet. But never mind that, because the government will pay their rent for them and, if you jack it up a bit more, they’ll pay that too! And where will the government get the money to pay the rent? They’ll borrow it from banks and, when they need to pay that back, they’ll just borrow some more!
And pretty soon, the vast majority of the country is living in a property they can’t afford, either because they took out a loan to pay for it, or because the government it taking out loans to pay their rent, or both, because in some cases the government will even pay your mortgage for you. And if you think this is all getting a bit crazy, then there will always be some savant on hand to tell you that it is good that a basic human need like shelter has become unaffordable, since deflation is very bad, and it’s good that people are busily spending far more than they earn since this stimulates the economy, and it’s good that everyone is up to their neck in debt and gave up saving years ago as a waste of time, because there’s a “paradox of thrift” (the only paradox, of course, consists of turning over the nation’s economic policy to people who say things that would shame the mentally ill). The beauty of the system is that the more people take loans to buy homes they can’t afford, the more the prices go up and the more the prices go up, the more people take loans to buy houses they can’t afford. And it seems as if this can just go on forever
5) And then – Kaboom:
The tragic thing is that most people think the ‘kaboom’ stage of this process has already come, when, in for great swathes of the world, it has barely begun. I hope to deal with what I think is the blindingly obvious policy implication of this story in a later post, but the point I want to emphasize here is that it is not remotely difficult to understand what happened in the years leading up to the crash and it only seems so to most people because they are bamboozled by experts talking about ‘liquidity traps’, ‘the velocity of money’, ‘demand deficiency’ and other concepts that don’t seem to make any sense because they don’t make any sense.
Take a simple thought experiment: you have ten apples and you eat one, now you only have nine apples. What this teaches you is that when you consume wealth, you have less wealth. One of the fundamental premises of the sub-Keynesian consensus of our age is that when you consume wealth you have more wealth. Any conclusion that can drawn from this starting point is nonsense, because it is itself nonsense.
Unfortunately, as we have seen, it is possible to create economic institutions that, for a time, can make nonsense of the real world. To state that you can become better off by buying a house is no less nonsense than to say you can become better off by eating an apple, but this is precisely what actually happened and millions upon millions of people have become so accustomed to this that they think of it not as a freakish aberration, but the normal course of things. Governments of all stripes strain every sinew to make shelter even more unaffordable and otherwise sane people greet every apparent success in this cause with applause.
There’s only one thing you can do in response to this: think. It won’t make you much happier, and it won’t make you much richer since the only way to profit from a boom is to go all in and get out just before it pops and no amount of thinking will tell you when that will be. However, truth can be it’s own small comfort and, at least, as the world continues to get worse and worse over the next few years you won’t greet it with the same bemused rage as many of your fellows.