The Prime Minister doesn’t understand the dynamics of rising house prices

The Sydney Morning Herald has reported that:

Prime Minister Tony Abbott has welcomed increasing house prices in Sydney on the same day the head of Treasury voiced strong concerns about a developing housing bubble in the country’s largest city. 

“As someone who, along with the bank, owns a house in Sydney I do hope our housing prices are increasing,” Mr Abbott said in question time on Monday.

“The important thing is to ensure that our economy is as strong as possible so that people have as much resources at their disposal as possible, have jobs, so they can go out there and buy the things they need, including the housing that they need.”

 Tony Abbott: F#*k the first homebuyers, my house is going up in value.
Tony Abbott: F#*k the first homebuyers, my house is going up in value.

There are a number of fatal flaws in the Prime Minister’s thinking.

The first is that the economy is not improving and people (particularly first-time buyers) are losing the ability to buy houses. Here’s why

House pricesWages are declining relative to prices having been stagnant since 2004 and declining since 2007. The only people who are putting money into real estate are the relatively well-off who are buying investment properties.

The current surge in  housing investment is fuelled by very low interest rates, not by people’s ability to repay the loans.   Some of us can still remember interest rates on housing going as high as 18%.

But with record low interest rates at present, the chances are that in the foreseeable future (well within the term of the normal home or investment loan)  interest rates will rise.

Perhaps not to 18%.  But rises in interest rates, which often occurs when the economy improves are part of the normal long-term economic cycle.

Historical Interest Rates AustraliaIt’s the left-hand side of the graph that should make people cautious about investing. A combination of the continuing trend of declining wage growth and a return to higher interest rates will prove disastrous for many real estate investors and home buyers.

So the first fallacy in Tony Abbott’s thinking is that it’s a good time to invest because interest rates are low and not because the economy is booming and wage growth is high.

The second fallacy is that rising house prices are good for homeowners. This is only partly true. The only time when increases in house prices are important is when you sell. For all the other times, it doesn’t matter.

Now if you’re selling to buy another house, the house that you’re going to buy has also been going up in value. Most people are upwardly mobile when it comes to buying another home. This means they will spend more on the next home than they get for the old one.

Take a family that buys a three bedroom house for $500k and plans to buy a four-bedroom one for around $750k when the family gets larger.  This is what house prices rising at 10% per annum will do to their plans.

HomeInitially, the difference between their current house and their intended house is $250k. After 12 years, that difference has blown out to $1.2m.

Tony Abbott thinks that’s a good thing.

The only people who benefit from rising house prices are the  empty-nesters who sell the family home and downsize to a less expensive apartment. They will probably be left with a significant capital gain which they can plough into a negatively geared investment property.

Oh, and the kids will benefit when you die.

Another aspect of increasingly expensive housing is that a large amount of the community’s capital is tied up in housing which is essentially a non-productive asset.

If governments were able to limit the amount of capital that was invested in housing, they would free up capital for investment in industry and stimulate the economy.

But this is far too complicated than idea for Tony Abbott to be able to grasp.

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