There is now widespread recognition in the echelons of government, both Federal and State, that we face an affordable housing crisis. However, there is still no consensus about how to solve it.
The Coalition insists the problem can be fixed by bringing on more supply. Labor regards a supply only market-based approach as too simplistic, and accepts the need also to address demand-side management, including through reform of negative gearing.
Malcolm Turnbull and Scott Morrison now seem to accept that we have an affordable housing crisis, as does our newly minted NSW Premier Gladys Berejiklian. The only question is what to do about it.
The Coalition’s recipe has three ingredients – supply, supply and more supply. This blog-post questions the economic rationale of the Coalition’s singular focus.
No one would dispute that increased supply is an important ingredient in affordable housing reform, provided it is steady, of the right type, in the right places and at a price that ordinary people can afford.
Unfortunately, these provisos are simply not being met and a supply only market-based approach is unlikely to ensure a satisfactory outcome.
There are at least three reasons why a supply only approach will not work:
- First, the housing market exhibits low levels of “price elasticity” (ie. responsiveness to changes in price);
- Second, housing prices have gotten so out of whack that affordability needs to be clawed back, not just stabilized, particularly for lower income earners; and
- Third, speculative investment demand has been fanned by a range of non-market interventions like negative gearing and the CGT discount, creating distortions which are only fed by more supply.
The laws of supply and demand
To assess whether the Coalition’s supply only focus stacks up, it is worth examining the economic rationale of this policy position and the laws of supply and demand.
In a perfectly functioning market, those laws go something like this:
If demand exceeds supply, then (all other things being equal) prices go up. As prices go up, supply rises to meet the excess demand until an equilibrium is reached, at which point prices stabilize.
By the same token, an excess of supply over demand generally results in prices falling. As prices drop, demand rises to meet the excess supply until, once again, an equilibrium is reached.
These laws therefore rely on market-based mechanisms, with price the principal determinant of the level of supply and demand.
For price to play a significant role in influencing supply and demand, the housing market would need to exhibit a high degree of price elasticity.
That is simply not the case.
An owner-occupier’s demand for accommodation is largely unrelated to price, except when price becomes prohibitive. Such demand is, in economic terms, relatively “price inelastic”, in much the same way as the demand for health services.
The lead-time for supply of new housing is relatively long and uncertain. Supply in the form of new product is therefore not responsive to shortages in the short term.
Even in the longer term, price elasticity is limited, as both supply and demand are influenced by a range of factors not directly related to price. These include planning rules, credit availability, interest rates, general consumer confidence and tax settings.
Price stabilization is not enough
Another fallacy of the heavy reliance on market mechanisms (including the economic effect of increased supply) is that it will of itself bring forth affordable housing, even if supply and demand move into equilibrium.
If increased supply does in fact cause prices to stabilize, that price is still likely to be at an absolute price level far out of the reach of a significant and growing proportion of the population.
The recent Demographia International survey of housing affordability accords Sydney a median house price multiple of 12.2 times – more than twice the threshold Demographia regards as “Severely unaffordable”.
At these levels, getting back to affordable price multiples (below 3.0) clearly requires far more than supply-led price stabilization.
Speculative demand pressures created by negative gearing
Current tax settings, particularly negative gearing and the generous CGT discount, have distorted the market by encouraging speculative investment demand in search of tax sheltered capital gains.
A belief by these property speculators that the market will keep rising ensures that higher prices not only fail to dampen demand, but rather spur further demand. In this respect, housing displays characteristics more resonant of an investment good rather than a consumption good.
The Federal Government is right to treat increased supply as an important ingredient in addressing housing affordability, and to look at ways of easing supply. However, it is a mistake to rely solely on that and to ignore other avenues for reform.
A pure supply-led focus is too simplistic. It ignores the fact that the housing market exhibits low levels of price elasticity and that prices are already largely unaffordable.
Amongst other structural reforms, we need to address demand side management, including the distortions caused through tax settings like negative gearing and the excessively generous CGT discount.
Housing is too fundamental a human need to be left entirely to the ravages of the market. This is particularly so for those on lower incomes, but also increasingly the case for those in middle income brackets.
Oliver Frankel is a former corporate finance and M&A lawyer, who has spent the second half of his career in finance, investment and management. Most recently, he has taken a strong interest in how to address the affordable housing crisis.