Higher House Prices Is Higher Prices

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In
this article, I will argue for the theory that higher house price
really is higher prices. Yes, I know what many of you must be thinking
right now. Probably something like “Stefan, what kind of a theory
is that to argue for? What is the next revolutionary theory are
you going to argue for? That higher apparel prices is higher prices?
That bigger cars are bigger than small cars? That income taxes are
taxes?" Yet while you are right in thinking that the fact that
higher house prices are higher prices is an obvious truth, this
doesn’t mean there isn’t a need to argue for it.

Because
the sad fact is that official government statistics on inflation
are based on the assumption that a house price increase really isn’t
a house price increase. Moreover, some prominent economists even
argue that a house price increase really is a house price cut! Since
the people who argue that a price increase isn’t a price increase
thus includes very important people, it is thus necessary to point
out why they are wrong.

First,
let’s deal with the official government statistical view that house
prices are irrelevant when determining the cost of living. This
is usually justified by the view that houses are assets and since
the consumer price index is supposed to determine the cost of living
and not asset price movements it must be excluded. Instead they
use a measure called “home owner’s equivalent rent” which is based
on local rent levels minus the costs for home owners which for tenants
is included in the rent.

Yet
there are several problems with this. First it is not really directly
obvious why you should exclude asset prices from inflation measures.
True, asset purchases are not consumption so to the extent that
the purpose of the price index is to measure strictly the cost of
consumption then this is a proper procedure. Yet as most people
are not merely consumers but also investors then any gauge of the
purchasing power of money should include asset prices. Asset price
inflation means that people can acquire a smaller amount of assets
for any given income so this means that the real value of their
income have fallen if asset prices rise.

Secondly,
even accepting for the sake of the argument that asset price increases
shouldn’t be considered inflation then it still doesn’t follow that
house prices should be excluded. House prices are namely very different
from the prices of other assets like stocks and bonds. Unlike stocks
and bonds whose value is derived from the future present value of
the cash flow that the holder of the stock or bond will receive,
the value of a house is derived from the future consumption services
(housing service) it will provide. A house is in short, a durable
consumer good like a car or a refrigerator. While it is true that
one can buy houses for investment purchases this does not change
the fact that the house price will reflect the cost of consuming
housing services. You can buy or sell cars too, as well as the commodities
underlying goods, but no one has suggested that we shouldn’t use
the actual prices of those goods because of that.

Moreover,
using rents as a proxy for the consumption involved for the home
buyers is bound to be extremely misleading as the market for rented
housing and the market for purchased housing are completely different
as they involve people with very different preferences. Just imagine
how misleading it would be to use the price of car rent or taxi
fares as “car owner’s equivalent rent."

An
even more absurd theory was launched by Russel Roberts, an Economics
professor at George Mason University who argued
that higher housing prices really means that the cost of housing
is falling! Interestingly, he later added a note where he wrote
that he was no longer convinced of the theory and will return with
a new post once he gets his logic straight. But while we wait for
that to happen, I’ll help straighten out his logic by pointing out
just why his original posting was wrong.

First
of all, he claims that house price increases unlike most price increases
make you better off. But the fact is that all price increases makes
the seller better off, while making the buyers worse off.
While most western countries become poorer as a result of rising
oil prices, Norway by contrast have become so rich that the government
don’t know what to do with the money. Its annual budget surplus
is more than $40 billion or $9,000 per person, which is actually
higher than the annual per capita revenues of the U.S. federal government.
Meanwhile its oil fund where they save the surpluses created by
oil revenues now has $200 billion or $45,000 for every Norwegian
man, woman and child. The government financial assets (forget about
debts) per capita is now higher than annual GDP per capita in the
United States. So the Norwegians sure wouldn’t agree with the claim
that price rises makes you worse off. Thus if you are a net seller
of something you benefit greatly from higher prices, but if you
are a net buyer you loses from higher prices.

Applied
to the housing market this means that first time home buyers will
most definitely lose from higher housing prices. But won’t existing
home owners win? Well, that depends. If they sell their home and
move to rented housing or some place where the prices have risen
less, then it is true that they will gain from price increases.
But if they stay in that house or if they move to some other house
whose price has risen as much or more then they will not have won
anything (in the case where they move to a house which have risen
more in price they will in fact have become poorer). That is because
if they hold on to it then they will both be “seller” and “buyer."
This is most obvious in the case where they sell their old house
and buy a new house who have risen as much in price, but by holding
on to their house they are in fact “implicit buyers," incurring
a opportunity cost by not selling their house to someone else. Once
again, oil provides a good analogy. It might seem strange that the
United States loses from higher oil prices while Norway gains given
the fact that oil production in the U.S. is actually much higher
than in Norway. The reason for this is of course that Norwegian
oil consumption is much smaller than its production while American
oil consumption far exceeds its production. Had the U.S. had roughly
equal levels of oil production and consumption it would neither
have been a winner or a loser. Similarly, as long as a home owner
is not a net seller of houses then they will not gain
from higher prices.

Partly
related to his inability to separate the different effects of price
changes on seller and buyer, Roberts makes the mistake of trying
to claim that current home buyers will gain from the price increases
that have happened. Just how you could possibly gain from higher
prices of something you haven’t yet bought is not exactly clear.
Presumably he meant that one should extrapolate these rates of price
increases into the future and that this will make the cost of housing
much lower. But even setting aside the above point of how it is
only under certain circumstances that home owners gain from price
increases and assuming for the sake of the argument that they will
meet these conditions and setting aside also the curiousness of
assuming that higher current price increases must mean that price
increases in the future will also be higher than in the past (I
would actually say that the opposite is more likely), he is discussing
a completely different issue. Namely, whether or not it is a better
or worse deal to buy a house or rent it. In that context the issue
of capital gains will be relevant. But this deals with the issue
of the absolute level of housing costs for home owners, not
its change, the latter being what an inflation gauge is supposed
to measure.

If
a home buyer a year ago could count on a 10% capital gain to reduce
their costs, then that cost reduction will not increase if there
is a similar capital gain during the coming year, resulting in unchanged
costs. In fact, the fact that there have been such rapid price increases
so far means that it is likely that future price increases will
be slower, something which in turn given the “capital gains lowers
housing costs” theory means that current home buyers faces higher
costs than in previous years as the cost reduction from capital
gains will be lower. That in turn means that the inflation rate
should be considered higher as a result of higher house price increases.

So
as we can see, higher prices for houses really is…higher prices.

September
27, 2005

Stefan
M.I. Karlsson [send
him mail
] is an economist working in Sweden. Visit his
blog
.

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