Thursday, June 25, 2009

Irrationality in economics and housing

Orthodox economics is often assumed - by both lay people and economists - to be a bastion of rationalism, where 'free markets' dictate optimal outcomes.

Of course, this rationality is not true, and the optimality begs the question of what or who a given free market outcomes favours. And whether we, as a society, want - 0r know - all of the ramifications of a particular outcome. This is one reason we legislate.

In economics as in all human endeavours, there is a frequently-hidden lack of rationality in human behaviour. With some experience with economics, it becomes apparent that 'free markets' lie at the intersection of rational determinism and irrational human psychology. Those at the libertarian end of the spectrum who favour removing the shackles of legislation are often ignorant of, or concealing, the full implications of such action.

Ross Gittens, the Sydney Morning Herald's Economics Editor, is fond of exposing the oddities of economic outcomes due to human behaviour. His latest commentary pertains to the effects of the government's First Home Owners Grants. On the face of it, the grants might sound laudible: with a housing market that is increasingly beyond the reach of new owners, taxpayers subsidise new entrants; and at the moment the economic stimulation would be a good thing.

However. The grants have been entrenched since 2000, well before the economy needed stimulating. Although they are now being treated as stimulation, the nett effect in this sense is that removing the grant would depress activity. Yet it has also been claimed that a cost to the government of $200m has blown out property prices by $3b.

Gittens argues the case that the raw appeal of free money has been responsible for a good number of the new housing entrants. His point is that this housing activity has been greatly exacerbated by the psychological effect of touting the grant as a 'limited offer' (which it currently is) of 'free money' - so grab it now. As a result, so many new players at entry level have been driven up the price of an entry-level home by more than the value of the grant. He suggests the best action is to wait for the grant to finish, and buy in when prices fall by more than the grant's value.

Of course, the other side of the coin is the creation of a property bubble that can induce a lot of defaults by people who have over-committed and whose situation then changes (usually through the reduced income of unemployment). This may well coincide with falling house prices once the grant comes off - and higher interest rates kicking in. This potentially risks affecting any economic recovery - making it much weaker and slower, or collapse altogether. Yes, interest rates are at their lowest since 1968. But the average Sydney house price in number of years of average earnings has shot up to nine times average annual income - more than the seven times average of the US and UK when their property bubbles burst (see here). It was three times the average annual earnings from the 1950s through the 1970s, which gives an idea why housing was more affordable for previous generations.

Gittens also gives as example a limited-time offer of $1m superannuation contributions being made tax-free, which induced people to borrow to take advantage of the tax windfall, only to see the investment crash by a far greater amount (than the tax benefit) when the sharemarket crashed. He reports advice - a general truism - not to get so carried away as to buy assets that weren't needed, nor take on more debt than could be handled. In these times of uncertainty, due caution helps.


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Stephen Simmonds said...

Well... okay...

I let this comment publish because it is so odd it stumps me.

That web site seems to be nothing more than an aggregator of blog postings that includes the word 'grant'. Maybe there's some slight remuneration for adding content to that site. However, the site gives no identification or raison d'etre.

The poster of my content identifies themselves there as Wilmer, and here as martha. Martha has a most peculiar blog (you can follow the trail to it if you feel so moved), which seems to be somewhere between random words, a senseless mashup, and a poor auto-translate into English.

Any explanations welcome. Otherwise, I'd have to assume it's an attempt to attract traffic for ads...