Housing needs supply-side fix

Dr Oliver Hartwich
Australian Financial Review (Sydney)
1 December, 2020

One of the shortest jokes about economics goes like this: Teach a parrot to say supply and demand, and you have created an economist.

But there is an even better joke: Teach a parrot to say demand and demand, and you have created a politician. And there are a lot of political parrots squawking about the housing crisis – on both sides of the Tasman.

In Australia, Liberal MP Tim Wilson wants to unlock superannuation savings so young people can buy their first home. In New Zealand, Prime Minister Jacinda Ardern has hinted at providing extra subsidies to first-home buyers while telling off the Reserve Bank of New Zealand governor for flooding the market through quantitative easing.

They both want to help, but the economics just do not stack up. A housing crisis cannot be solved by demand-side measures – particularly ones like these that increase demand.

For centuries prior to the Marginal Revolution, economists were puzzled by what determines the price of something. Was it the cost of production? Or was it the demand for it? Thinkers from Thomas Aquinas to Adam Smith and Karl Marx could not figure out the answer.

The riddle was finally solved in the late 19th century by economists in Britain, France and Austria, and their answer was that it was both supply and demand. Or, as English economist Alfred Marshall put it, “we might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper.”

It was Marshall, too, who popularised the use of downward-sloping demand and an upward-sloping supply curve. And just where these two curves intersect, the market determines both price and quantity. Reality is much messier than this Economics 101 nutshell, but this stylised demand and supply diagram remains a good shortcut to understanding how the markets work.

What the politicians above do not see is that giving buyers more money will only make more people want to buy a house. In technical terms, it shifts up the demand curve. Such a demand boost can come from lower mortgage rates, access to more funding (say through superannuation) or government grants.

But this intervention does nothing to change the shape of the supply curve. Thanks to zoning laws, lack of infrastructure funding and building regulations, the supply curve rises almost vertically. Economists call this type of supply “inelastic” meaning that the amount that can be built is more-or-less fixed. Higher house prices do not translate into more building activity.

So, how can housing be made more affordable? If politicians want to help, they could lower demand or increase supply.

The first option sounds simple, but lowering demand is messy. Stamp duties, land taxes, capital gains taxes can all reduce housing demand. But taxes have side effects. Not least do they introduce frictions in the market’s equilibrating process. And lowering demand usually means making people poorer. Not the best move for any politician.

A much more promising option is to push up the supply curve by letting the market add more houses quickly if prices rise. Unlike the demand side interventions, such a policy focus would not come with many negative side-effects. However, it requires more effort and creativity on the part of the politicians.

The rewards of turning on the supply tap are well-documented. Richard Florida, author of The New Urban Crisis, compiled data for the major US cities over a 30-year period. For each of them, he calculated changes in real home values and the expansion of the cities’ developed residential area.

The results were instructive. Some backwater cities neither expanded nor got more expensive. But the high-growth places either they expanded their residential areas and kept house prices stable (e.g. Las Vegas, Atlanta or Austin) or their residential footprint stayed the same as house prices rose sharply (e.g. San Francisco, New York or Los Angeles).

That is the choice now facing both Australia and New Zealand. Will their cities be expensive or expansive (which could mean both building up and out)? The answer depends on whether politicians can make it easy to build new houses and infrastructure quickly.

But none of this is being discussed on either side of the Tasman. Instead, politicians keep focusing on demand while sliding any supply reforms into the “too hard” basket.

Voters should ask a simple question about any new housing proposal: Will it make it easier to build more homes? If the answer is not “yes,” these are not the policies Australia or New Zealand need to fix our countries’ housing crises.

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