What are the possibilities for the future housing prices? What can we do?

Two eminent but retired Reserve Bankers, Don Brash and Arthur Grimes, have argued that house prices should halve. I am not sure whether they actually mean it or are just vividly pointing out that house prices are about double the sustainable level. I probably use a different method of calculation but have come to a similar assessment. (See here for an earlier attempt at the exercise when the imbalance was not as great.)

But while housing prices may be too high, will they crash? My 2007 exercise thought they might stabilise until consumer inflation caught up with them. Nine years later, inflation is negligible and house prices are even further out of line. A reconciliation through this inflationary mechanism is unlikely.

Could house prices collapse to half their current level in the way that some people have interpreted Brash and Grimes? If they did, the impact on the financial sector would be disastrous. For the vast majority of owner-occupiers, a halving of house prices would have little effect. They would get up each morning in the same house, pay the same rates, insurance, maintenance and mortgage and live much the same life with the same cash flow. Things might be a little trickier if they decided to change houses, but that difficulty would not compare with those faced by the minority of house owners – occupiers and investors – whose mortgages now exceeded half the current value of their houses.

If house prices were to halve, they would be, in the American jargon, ‘under water’, with the temptation to walk away from house and mortgage. Many owner-occupiers might not, but the pressure on investors would be to get out, dumping the house and mortgage onto the bank which lent the cash. Very quickly the banks would find themselves with a portfolio of houses they owned whose value was not matched by what they had borrowed to fund them.

In the well-oiled world of simple economic theory, this would not matter but in advanced economics and the real world it does for at least two reasons. First, the transaction costs of dealing with the investor bankruptcy are large. Second, the balance sheets of the banks would likely be so screwed up that, in order to prevent their failing, the government would inject large quantities of taxpayers’ money into them – effectively nationalising them.

However, I do not think a rapid fall in housing prices is likely. I am not ruling out a 10 percent fall or even a 20 percent fall for distressed selling. But I think a 50 percent fall is unlikely (although the Reserve Bank is prudent to take that possibility into account in its settings).

The reason for my scepticism is that there is a phenomenon called ‘nominal price rigidity’ in which general price levels do not fall even though economic analysis says they need to in order to clear the market. It arises because where people’s attitudes about monetary values are such that they are reluctant to reduce their offer prices.

That makes zero or negative inflation so difficult to handle, because so prices have to fall. But it is best studied in ‘nominal wage rigidity’; when workers refuse to cut their remuneration as unemployment rises. I am anticipating that home owners will be similarly unwilling to lower the price they want for their houses markedly and would not put them on the market. (Investors have to, when their mortgage is costly.) The net effect would be that the housing market would have few houses for sale, which would be tough on those who want to purchase or need to move; that seems to be already happening in some localities.

At this point we reach an impasse. Houses prices are markedly out of balance with the rest of the economy’s prices and wages. Consumer price inflation is unlikely to resolve the imbalance, while a slow decline in house prices will take ages and ages with the damage from the imbalance continuing. A major house crash will cause financial chaos. So how does the mess unwind?

I do not know, but my intuition is that any resolution is going to involve taxpayer money. Ouch! Exactly how that will happen depends on contingent events and political decisions. (I would hope that if taxpayer money was to be used, a good chunk would go to enable the purchase of first homes; although that would reflect a different political ideology from the one which has dominated the last three decades of ‘the boats are for the well-off’.)

We have got into this muddle because there has not been the political foresight to see it coming or to take action to prevent it. As too often it has been ‘full speed ahead and damn the torpedoes’. When they strike many will find themselves under water. 

An AUT Policy Briefing paper I wrote, Over-investing in Housing, which looks at the impact of taxation concessions on housing is here.