Supply or demand – why not both?

I’m a little perplexed to see Gareth Morgan come out railing against the Productivity Commission’s report on the housing market.  Now when it was released, I thought the focus and justification were a bit funky – but that the analysis seemed largely sound.

Gareth’s posts have been found here and here.  He says that supply is not the issue, its demand due to the tax status of housing and the Reserve Bank.

Seamus Hogan at Offsetting has covered off why this critique of the PC seems weird, so I’d suggest reading that.  As Seamus says, it is incredibly strange to treat the supply and demand factors as mutually exclusive – both can exist.  In fact to justify house prices being “too high” while the volume of the housing stock is “too low” REQUIRES a large supply impediment.  If what Gareth said was the whole story we would be experiencing overbuilding!

Why is that?  Well if something is boosting the demand for existing housing beyond what is “socially optimal” this bids up the price for existing houses while the cost of making a new house is unchanged.  As a result, there will be a lift in demand for new houses as well, leading to a lift in building activity (and building costs) such that we are building more houses than is “socially optimal”.

We could well debate whether this was the case pre-crisis – we know that expenditure, and volumes, or residential investment were very high between 2002-2007, but we also have some suggestions that much of this was due to increases in the size and quality of housing.  We were buying “more house”, rather than more houses.  Even during 2007, there were still concerns that there was not enough houses in some key regions – unlike the US experience there was not a wide view that we were “oversupplied” in terms of our housing stock.

Come to the post-crisis period and it is widely believed that we have a massive undersupply of property in Auckland (and Canterbury, but that is due to the quake).  House prices are still elevated, RBNZ policy is still “friendlier to mortgage debt”, but building activity is damned low!  This is far more than a cyclical downturn – there are significant issues of financing and co-ordination in the industry. “Reducing demand” doesn’t change this – and doesn’t make policies that are looking at the supply-side issues irrelevant!

The key point against supply side issues will be the fact that rental growth hasn’t gotten scary at any point – is there are “too few” houses, then we should really see the cost of housing services/rent pick up.  This suggests to me that any perceived demand side issues are also important, and should be taken into consideration [Note:  Think of demand issues in this context as things that increase the wedge between the individual rate of return on housing and the social rate of return – as this leads to people being more willing to use housing as an investment vehicle for a lower relative rate of return, the rent 🙂 ].  Once again though, supply and demand are not mutually exclusive.  The fact we are looking at one doesn’t mean we throw the other away.

One final note – the Productivity Commission spent a long time getting together facts and figures in order to make its case for why the supply issues were dominant.  And they also made note of perceived “misallocation” issues and the such stemming from the demand side.  Gareth’s decision to just out of hand dismiss what they are saying and state that the answer is “obvious” is a touch grating.  I don’t think the Productivity Commission (or myself for that matter) would disagree with the points he raised … as they aren’t mutually exclusive – I’d say I just weight them less severely than he is because I am willing to accept that there are supply side issues which are behind part of the price lift.  And I think this is the reason the supply issues are being attacked … just to increase the “weight” people place on the demand side.  I’m not sure I agree with this.

Note:  Remember that show Heroes, where they say “save the cheerleader, and save the world”.  The building issue in NZ has had a significant impact, both in terms of the run up of debt and the allocation of resources – in many ways people have been “saving” in a vehicle that might not give them the return they expected in terms of future goods and services!  Given this, understanding these issues is important.  You could even say “save the housing/building industry, save New Zealand”.  I’d avoid that though, because “saving things” always seems to involve subsides and bailouts which is not really what analysts are suggesting …

Update:  Seamus cleans up some of the places where my language is too loose.  His clarifications are entirely right.