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