Housing supply down, profits up

November 11, 2009
By

The Age

HIGHER land and house prices typically lead to an increased supply of housing. Yet at the peak of Australia’s perennial housing affordability crisis, the Housing Industry Association declared that there would be a 13 per cent fall in housing starts this calendar year, compounding last year’s 18 per cent fall.

In light of massive rezonings in Victoria and improved planning bureaucracy in many states, this can only be seen as a warning that property insiders expect there to be a price crash.

The public face of the housing industry is quite different. So, what do property investors expect that the rest of the population does not?

Government spokesmen reflect assurances by bankers and their major category of customers – the real estate industry – that Australia’s economy is defying gravity. In reality, that is as impossible in economic life as it is in physical nature.

Property prices are defined by how much a bank will lend. Donald Trump claims that a man is worth what he can borrow. This usually depends on what a borrower can afford to pay, after meeting basic break-even needs (the cost of living, plus taxes). In the corporate sector, it means after-tax cash flow. So property prices are set by the banks, subject to the tax system.

The motto of real estate investors is that rent is for paying interest – and whatever the tax collector relinquishes is available to be capitalised into a bank loan as a flow of interest payments. The guiding idea is that affordability determines property prices. One example of how the tax system affects property prices is in its failure to distinguish land from capital improvements. Speculative withholding of prime locations from the market in an undeveloped or unsold state creates artificial scarcity. This raises prices.

Property speculators are able to afford this hoarding to the degree that the land’s potential site rent remains untaxed. Taxing the land would bring underutilised land and other property on to the market. It also would reduce the available free-lunch rent that is currently capitalised into bank loans to raise prices.

The myth is that higher property taxes increase the cost of housing and office space over time. The reality is that higher taxes would leave less site-rent to be pledged to banks – thereby reducing the financial cost of property ownership – while also enabling the government to shift the tax burden back off labour on to property, as used to be the case in Australia before the mid-1970s.

This explains why the financial lobby supports the real estate lobby in shaping public perceptions of the property market – along with government financial policy towards the finance, insurance and real estate sector.

Australia’s fiscal-financial system has become increasingly dysfunctional in giving tax preference to land-price ”capital” gains and hence property speculation rather than tangible capital formation. Instead of raising living standards by producing more, what passes as post-industrial ”wealth creation” takes the form of inflating asset prices on credit. The result is a bubble economy. And inasmuch as asset-price gains are fuelled by debt leveraging, wealth creation is more accurately viewed as debt creation.

The problem is that debts remain in place even as prices drop.

And they are dropping in response to the economy’s shrinking ability to pay, as more and more income is earmarked to pay debts run up in the past. This debt service is not available for spending on goods and services. The result is debt deflation. Lower spending on goods and services shrinks the domestic market (and also shrinks imports), leading to lower business profits and also lower business rentals. Lower rental income results in lower property prices – and at a point, property falls into negative equity: the mortgage debt exceeds the current market price that home owners or commercial investors can recover.

This is the end stage of debt-leveraged bubbles. In this respect it behoves Australians to look ahead. It seems that Australian property investors are also doing this. How else to explain the cutback in new building?

Michael Hudson is distinguished research professor at the University of Missouri.
Read Bryan Kavanagh’s feedback on some of the comments to this article on The Age website.

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