Tuesday, 20 October 2015

House Prices and Supply

Last week I heard a Tory housing spokesman come out with the same rhetoric about the answer to high house prices being to increase the number of houses built and supplied. It shows a remarkable lack of understanding about how capitalist production takes place.

The only reason that capitalists produce anything is to make a profit. No matter how much need there may be for something, be it a kidney dialysis machine, or a house, capitalists will not produce it, unless they can make a profit from it. Whether they can make such a profit depends, firstly upon the cost of producing it, and secondly upon those who need it having the necessary funds to buy it at a sufficiently high price that exceeds those costs. That is why, very expensive products are initially the preserve of the very rich, and only become possible for others to buy, when the cost of producing them has been massively reduced.

The fact is that capitalist house builders are not acting perversely by not building many more houses, to meet the supposed demand for housing. They are acting quite in harmony with the laws of capitalist production and exchange. Suppose builders cost of building a house is £190,000, and they can sell this house for £200,000, in a market where they produce and sell 100,000 houses in a year. So, they make £10,000 profit or 5% on their capital.

Now, suppose they produce 200,000 houses in a year instead. If they can only sell 100,000 houses at this price of £200,000, then they will have over produced 100,000 houses at this market value. This is what Marx calls a partial crisis of overproduction – partial because it here only affects house builders. As Marx sets out, in his analysis of such crises of overproduction, the result is that, in order to sell the 100,000 surplus houses, builders will have to reduce the market price, down to a level where enough additional consumers can be attracted so as to demand the whole 200,000.  The market price is now lower than the market value, and may even fall below the cost of production.

But, this reduction in the market price does not then just affect the surplus 100,000 houses, but the whole 200,000. Suppose, that in order to raise demand to 200,000 per year, the builders have to reduce the price of a house to £180,000. In that case, on each and every house sold, the builders would make a loss of £10,000, which, if it were to continue, would quickly send the builders into bankruptcy.

What is more, if the builders were to double their production of houses, it would have other immediate effects. Firstly, it would mean their demand for land would rise sharply, causing the price they have to pay for it to rise further. Secondly, a consequence of the lack of investment in productive capacity in the UK economy, over the last thirty years, means that whenever any large demand for things such as bricks arises, the UK is no longer able to satisfy it, because it does not have enough brick production. That means that the price of bricks rises, as demand for them outstrips supply.

For the same reason, there is a lack of skilled workers, such as bricklayers, joiners and so on, which is why many of these had to be brought in from Poland and elsewhere, in the early 2000's, when a construction boom pushed wages for such skilled workers to very high levels. Today limits on immigration introduced by the Tories, have made it more difficult to fill these skills shortages. The consequence is then, that if builders were to double the annual house building programme, not only would they have to sell each house at a lower market price, in order to generate the required level of demand (demand requires people have the ability to pay, not just a need for the house), but their own production costs would rise, so that they would make large losses on each house sold.

The reality is that, although there is considerable housing need, this is not the same as a large amount of unmet housing demand. Although some housing demand has been artificially inflated, by encouraging an increase in single occupant households, as well as the ownership of multiple dwellings, there is simultaneously a large number of families living in sub-standard conditions, as well as being homeless, but these families are unable to provide the finance to be able to create an effective demand for houses.

Builders only build 100,000 or so houses per year, and have done so for a long time, because they know that if they built more, they could not sell them at prices that would realise a profit for them. No amount of bleating and pleading for capitalist builders to build more houses will change that economic fact. The only way to change that situation would be if workers had much higher wages to be able to afford the current astronomical level of house prices, or else, the cost of production of houses were to fall drastically, so that builders could build more houses, and be able to sell them at a lower price, whilst still making a profit from doing so.

But, it has been the policy of inflating asset price bubbles, and encouraging huge amounts of private debt, which has created the situation whereby that is currently impossible. Firstly, from the 1980's onwards, workers wages were squeezed. The only way they could sustain living standards was by taking on increased levels of private debt. That was facilitated by the fact that from around 1982 onwards, interest rates were in a secular thirty year downtrend, so the cost of financing this debt declined, even as the level of debt soared ever higher.

Workers could not buy these ever more expensive houses out of their wages (house prices have risen by around 20 times, or two thousand percent since 1980, whilst wages have risen by nothing like that), and so had to take on ever larger mortgages, that in turn were justified only on the basis of ever higher income multiples. Where in the past, mortgages were limited to around 2.5 times family income, they became extended to six and more times family income, with often little verification of what the actual income and expenditure was to be able to make the mortgage payments sustainably. The consequence of this ever higher spiral of the property bubble, was that building land prices spiralled ever higher, and the price of the building land, is an important component of the builders' cost of production.

Suppose a builder faces the following costs. £10,000 for land, £10,000 for materials and labour. They are able to sell a house for £30,000, which was the situation back in the mid 1980's. That means the builder makes £10,000 profit, or 50% on the capital they have laid out. Now suppose, house prices continue to rise, so that this causes land prices to rise, which is also the effect of falling interest rates, as lower interest rates create a higher capitalised value of land.

If land prices now rise to £90,000, the builder may still face costs of only £10,000 for materials and labour, and although the price of a house rises to £110,000, the builder still only makes £10,000 on the capital they have laid out, which now represents just 10%. But, of course, builders, as capitalists, will demand to receive the same rate of profit on their capital as any other group of capitalists receives on theirs. The only way this is possible is if the price of the houses they sell is such as to give them this same average rate of profit.

If that rate of profit, is 50%, where it was originally, then the builder would have to sell their houses at £150,000. But, this necessarily means that they are able to sell fewer houses at this price than they could sell at £110,000. The only way this can be sustained, therefore, is for capital to leave the building industry, so that fewer houses are built, the market price of houses is raised, and the builder is able then to make the average rate of profit.

If the government really wants to reduce house prices, and to encourage more house building, it must first burst the current property market bubble. That would require a rise in interest rates, tighter restrictions on mortgage approvals, an ending of the government's bribes for house buyers, including the tax advantages handed to buy to let landlords. Once the current property market bubble is burst, that would in turn cause land prices to fall sharply, which would hugely reduce builders costs of production for new houses. It would mean a much larger number of houses could then be sold at a profit, which would increase housing supply further, causing market prices to fall further, creating a virtuous circle of falling land prices, causing falling production costs, causing higher profits, leading to an influx of capital into building, an increased supply of houses, and additional falls in market prices.

At the moment, this cannot happen because government policy acts in totally the opposite direction. The reality is that builders will not currently build more, because they could not profitably sell more. They cannot profitably sell more, because there is inadequate effective demand at the current astronomically high prices. Its not quite true to say that there is no more demand for additional houses at these prices, but it is effectively true. It is a good illustration of the point Marx makes in Capital III, about the fact that demand in a capitalist economy is a demand conditioned by very unequal distribution relations, which themselves flow from unequal ownership of the means of production.

It is quite true, for example, that there are some very, very rich people – whose fictitious wealth has grown even greater as a result of this process partly induced and encouraged by QE – who can buy houses until they come out of their ears, and very expensive, multi-million pound houses at that. There are thousands of £1 million plus properties in London, that have been built, bought, and remain empty, because they have been bought simply for speculation, for example. Government policy has also encouraged the development of a class of buy-to-let landlords, some of whom have the necessary wealth to buy property to rent, and many more who have the collateral, and rental income to be able to buy additional properties to rent out. All of this creates a potential demand to soak up the 100,000 or so new units produced each year, at prices that enable builders to make average profits.

Even to the extent that the buyers of property to rent, buy existing property, some of it will enable existing owners to buy some of the new additional units produced. There will always be some sections of the middle class, or even better paid sections of the working-class, who may be able to qualify for a mortgage to buy some of these additional units too. The point is that, the number of such families is limited, because of the astronomical prices of houses currently. So long as house prices remain at those massively inflated levels – around four times the historical average level – the number of workers who will be able to afford any such new additional units will remain severely limited, and almost certainly declining, so that there will be no basis upon which builders could profitably increase supply.

That is why, in periods such as those during the latter part of the 1930's, when new building techniques were introduced, and land prices were low, there was a sharp rise in home ownership in those areas of the country, such as the Midlands, and South-East, where workers were employed in new, relatively high paying industries, such as car production, and consumer electronics production. A similar thing happened after World War II, when in the 1950's and 1960's, wages rose sharply, so that workers could afford to buy houses, and builders could afford to build them in large quantities, alongside a large rise in council house building that kept down property prices, and also thereby land prices, whilst interest rates were rising.

By contrast, both in the UK and US today, we have very low interest rates, but a declining percentage of homeowners, as high property prices have pushed up land prices, making it more costly to build additional houses.


John said...

Could you clarify on how high house prices cause high land prices - thanks

Boffy said...


Sure. The price of land is the capitalised rent. That is if we take any amount of rent, say £1,000 p.a., and consider this rent, as the equivalent of an amount of interest upon a sum of money-capital, which could have been used to, for example, buy a bond, a share or other financial asset, the land price is then equal to the rent divided by the average rate of interest.

So, if the average rate of interest if 5% (5/100), the capitalised value of the land is (£1,000 X 100)/5 = £20,000. Put another way £20,000 at 5% interest gives a yield of £1,000.

So, the price of land then depends on two things. Firstly, the level of rent for that type of land, and secondly the average rate of interest. If rents rise, the capitalised value of land rises. If interest rates fall, the capitalised value of land rises. For example, if interest rates fell in the above example, to 2%, the capitalised value of the land rises to £50,000, because you need a £50,000 capital sum to give a yield of £1,000 at 2%.

As I've described elsewhere, this works because of competition, as anyone seeking a yield on their loanable money-capital can just as easily use it to buy bonds, shares or land, and can buy or sell any of these assets to achieve that.

Land rents rise, when the demand for land rises, which happens when the profits from its use rise. If speculation drives the price of existing houses higher - and for the reasons I've set out elsewhere, this speculation does not require that there is any significant additional new demand, only that existing owners of these assets, drive their prices higher between them - this has two effects. Firstly, it means that rents are driven higher, because anyone who cannot buy, rents, and the increased demand for rental properties raises rents. Secondly, the higher price of houses, means that builders, if they can continue to build houses at the same cost, but sell them at this new inflated price, thereby make surplus profits.

But, it is surplus profit, i.e. profit above the average rate of profit, which always constitutes rent. Suppose, the average rate of profit, provides a builder with £20,000 profit on a house, which sells for £100,000. If, speculation drives the price of similar existing houses up to £150,000, the builder can now sell at this higher price, and if all their costs remain the same, they will now make a surplus profit of £50,000. But, because land is in fixed supply, the owners of land are able to increase the price charged to the builder, so that this surplus profit for the builder disappears, and becomes instead rent for the land owner. In the past, builders leased such land from landowners, and so the actual rent increased, but today, mostly the land is bought from the land owner. But, for the reasons set out above in respect of the capitalised value of land, the result is the same.

This is compounded, by the fact that landowners, including builders themselves, who hold large amounts of land in land banks, seeing property prices soar as a result of this speculation, which has been underpinned by the actions of government and central banks, to give the false impression that property prices only ever rise over the medium to long term, will tend to hoard the land, rather than release it, in the expectation of making an additional capital gain on its sale later. Its a sort of credit crunch, where money is hoard, but instead its land that's hoarded, which pushes the price even higher.