Thursday, September 01, 2011

Are Higher Prices Good Or Bad?

It is generally assumed that higher house prices are good and that lower house prices are bad. Matthew Yglesias here points out that this is not always true. But while I basically agrees with his conclusion, his analysis is inadequate.

The assumption that house prices are better if they are higher rests largely on the fact that most home buyers borrow most of the money needed to buy the houses, and if prices falls after that then the mortgage debt could exceed the value of the home, creating problems for the home owners and/or the mortgage lenders. By contrast, higher house prices will seemingly create new wealth for the home owners and more or less eliminate the risk that the mortgage lenders will suffer losses.

Furthermore, higher house prices will make it more profitable to build new homes, creating a boom in the construction sector.

These argument are true as far as they go. however there are downsides to higher house prices.

First of all, higher house prices will all else being equal make it necessary for new home buyers to take on more debt, thus increasing the risk that they and their lenders will suffer from debt related problems in the future and also increasing their debt service payments. Thus, while higher house prices reduces current debt problems, it increases the risk of future debt problems.

And while higher construction activity is normally a good thing given a certain level of production of other goods and services, it could crowd out other production. And if there is excessive activity during a certain time, it could create adjustment problems when activity falls as workers and other factors of production often can't quickly move to other lines of production.

In short, there are pros and cons with higher house prices. This is also true more generally speaking regarding price changes.

All else being equal, higher prices are generally good for sellers and bad for buyers.

However, if dramatic price changes up or down creates malinvestments, debt problems and other adjustment problems then they might be bad for both [most] sellers and buyers.

On the other hand, positive productivity driven price changes might benefit both buyers and sellers. If for example, crops for farmers improve, then farm income might increase even though food prices fall, meaning that both sellers and buyers of food products benefit. Similarly if workers for whatever reason becomes more productive then they can receive higher wages even as the profits of their employers increase, meaning that both the buyers and sellers of labor gains.

In short, whether or nor price changes are good or bad depends on first of all whether you're look on it from the perspective of the buyer or the seller. And secondly on if it could later cause adjustment problems. And thirdly on whether it reflects productivity changes.

6 Comments:

Blogger Linus said...

The question which should be put is "is it good to allow the issue of housing loans". It is exactly the reason for prices for housing to be that high. If no loans would be allowed for housing, I am certain that house prices would be considerably lower and people who saved for maybe a period of 5-10 years would (maybe with the help of parents or friends) be able to buy a house. Today, banks calculate (at least in Switzerland) affordibility on the basis that you are able to pay the interest on a loan with roughly 30% of your income. The system is built to encourage debt (tax laws have been adjusted accordingly to favor this) which serves mainly the banks and not the population.

1:44 PM  
Blogger Shane Leavy said...

Surely the higher the cost of housing, the less money renting consumers and businesses have to spend on everything else. I would imagine high property prices could inhibit investment as businesses choose to set up in some other, cheaper region.

As it happens I have just started to rent a property in Dublin and it is much cheaper than the same kind of property a few years ago, during the boom. From my perspective this is great!

4:47 PM  
Blogger stefankarlsson said...

This comment has been removed by the author.

9:06 PM  
Blogger stefankarlsson said...

Linus, banning house loans is a terrible idea. Even if we set aside the unacceptable infringement of individual liberty it would damage economic growth as people who has been unable to save while having a good ability to pay back in the future due to for example a new high paying job, would be unable to take these positions if -as is often the case- rented housing is unavailable.

Furthermore, such a ban would by lowering house prices artificially make housing construction less profitable and create housing shortages.

However, it would be a good idea to end the artificial subsidies of housing loans through monetary policy, tax policy and the creation of entities like Fannie Mae and Freddie Mac.

10:33 PM  
Blogger Ari T said...

Btw out of curiosity, have you read the Less Than Zero by G. Selgin? If yes, I'd happy to hear your thoughts on it.

8:49 PM  
Blogger stefankarlsson said...

Ari, no I haven't read it, but I hope to do so soon.

8:56 PM  

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