Working Papers

House Price Inflation without the Froth

When confronted with asset price inflation, many economists are all too ready to declare a ‘bubble,’ which saves them the bother of actually having to think seriously about the economics underlying asset prices.  Fortunately, the BoE MPC’s Kate Barker is not one of these people.  In a speech to the IEA, she carefully examines the relevant fundamentals and puts them in a broader context, noting:

In previous speeches I and other MPC members have set out why it is generally undesirable to target asset prices when setting interest rates – particular reasons being the wide range of uncertainty around the equilibrium for any asset price, and the dangers to credibility of diverting policy from the goal of achieving the Government’s inflation target.

While RBA Governor Macfarlane has also highlighted the dangers of using monetary policy to target asset prices, the RBA’s public comments on house prices and private sector credit growth have diverted attention from its inflation target and confused the public and markets.  The RBA’s mistake was to express a strong (and arguably mistaken) view on house prices and private sector credit growth, but without being willing to actually take responsibility for outcomes in relation to these variables.  This was the right policy choice, but calls for a more agnostic public stance on these issues so as to keep the inflation target centre stage.

(thanks to Mark Harrison for the pointer)

posted on 24 February 2005 by skirchner in Economics

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I greatly respect your contrarian position on asset price inflation. But your underlying assumption of efficient markets seems to be unsound at times. For instance, did you believe that the dot.com bubble in tech stock prices reflected sound fundamentals?
ON fundamentals I have no problems with house price and construction boom. Good accommodation is a superior good. And interest rate falls have made it cheaper to finance.
The problem with housing prices is that they clearly are subject to overshooting. This seems especially the case with populist finance policies (first home owners benefit, CGT cut).
Also, housing value should be measured by its income earning, not price growth, potential. There is no evidence that housing is producing such extraordinary value to society, going by the flat state of rentals, esp in relation to comparable investments in R&D, human capital etc.
But keep up the good contrarian work.

Posted by Jack Strocchi  on  02/25  at  04:19 PM

My argument is not that asset markets never overshoot: clearly they do.  My argument is that such behaviour is in fact fundamental to the process to asset price determination.  If markets did nothing more than perfectly mirror known fundamentals, there would be no need for them.  We can never know the ‘correct’ price of an asset ex ante, because its price must necessarily incorporate considerable uncertainty about the future.  Because an expectation is shown to be invalid ex post, does not demonstrate it was irrational ex ante.

Posted by skirchner  on  02/25  at  05:12 PM

So the argument boils down to which agency is a better long term evaluator, actor and reactor to existential uncertainty: statist regulators or capitalist entrepreneurs. I think I can guess your answer to that.
I still have problems with your contention that AUS’s massive investement in accomodation is rational. The urban birth rate is down, and constrained, due to high city rents or land prices. We are well under the OECD’s par, let alone best practice, for investment in sci-tech R&D and human capital.
This has got to be worth more than yet another en suite.

Posted by Jack Strocchi  on  02/25  at  08:11 PM

It is not a question of rationality, but preferences.  How much of your own net worth have you allocated to housing compared to venture capital and private equity funds that invest in R&D?  Your choice says nothing about your rationality, only your risk tolerance and rate of time preference.

Posted by skirchner  on  02/25  at  08:35 PM

Australians do seem risk averse, going by the lowish rate of overall entrepreneurialism and the preference for investment in property (“safe as houses”) rather than equity.
This is probably bad for our current account since we produce less tradeable goods.
Our overall rate of time preference is also pretty pathetic, going by the low rate of saving.
These valuations, rather than the calculations, may be distorted by property-pampering tax-friendly policies esp the exemption of family home from CGT.
The older I get the more sympathetic I become towards Georgist tax policies (ie tax “given” resources and exempt “created” resources.)

Posted by Jack Strocchi  on  02/26  at  06:56 AM

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