The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Thursday, November 12, 2009

Elastifying housing supply

Traditional approaches to thinking about supply have concentrated on publicly subsidised construction programs that target those on the threshold of poverty. Many observers argue that State and Federal Governments should radically increase the stock of affordable homes to attenuate demand pressures. Yet aside from exhausting scarce tax-payer funds, these initiatives typically yield only a trickle of properties while spawning a new layer of bureaucracy. In both Australia and the US, the affordable housing movement has for many decades focused energetically on this line of attack with, we believe, limited results.

If a more enduring change is to be made to the functioning of our housing market, it will require much more drastic steps. As we have shown elsewhere, the root cause of escalating house prices is regulatory constraints on new construction. In view of such, the most effective way to reduce the costs of home ownership is through eliminating the major obstacles to increasing supply. This is, of course, much easier said than done. Academics have for a considerable period of time now been frustrated in their attempts to crack the housing needs-production mismatch by the wide prevalence of ‘NIMBYism’ (see Portney (1991), Downs (1994), Fischel (2001), and Nelson (2003)). Not-in-my-backyard style sentiments refer to the incumbent resident’s profound aversion to the prospect of relaxing spatial restrictions (this might go some way to explaining the existence of high cost, low density areas). In terms of the ownership opportunities available to ‘outsiders’, there is an inherent conflict of interest in having current property owners determine limits on dwelling dispersion. As a matter of fact, local government decision-making processes seem to be calibrated so as to minimise the supply of new housing, whilst maximising the value of existing properties.

In the context of a nation’s global housing objectives, this is exceedingly perverse. And yet council members must also have an intimate understanding of the issues that confront the households they represent. In a funny sort of way, this situation is analogous to the governance problems that tainted corporate boards in the 1980s. (Perhaps we should recommend that a certain proportion of councillors live outside their area of interest, in a manner not dissimilar to the premium public companies place on the role of non-executive directors!)

There may, however, be another explanation for the pervasiveness of this behaviour among owner-occupiers. NIMBYism could be a rational response to the absence of markets that enable residents to hedge the risks associated with changes in the values of their properties. Although the expected effects of fresh construction are frequently benign, households may be more concerned about the second moment—that is, its impact on the variance of expected outcomes (see Fischel (2001)). Since it is not currently possible for them to insure against fluctuations in property prices, they are instinctively doing the best they can to reduce the probability of some unlikely future event. This obviously intimates toward significant gains from trade were one to establish a market in which to exchange synthetic claims on home equity (Rismark is working on just such an initiative with RP Data and the ASX).

Returning to the task at hand, we can think of at least two trajectories that would help to liberate the supply-side so that it can more easily adapt to changes in demand. The first would be to create a centralized zoning authority at the regional or state level with the ability to approve projects quickly. This approach might afford a number of advantages, such as capitalising on economies of scale, and providing builders with a homogenous set of guidelines over wide tracts of territory. On the other hand, the costs could be quite high. It is, for instance, hard to imagine that this ├╝ber-authority would be able to successfully circumvent the prejudices of local partisans. Indeed, there is the distinct risk that it would have to engage in protracted negotiations with municipalities prior to any new projects being approved. Philosophically, we also think that there is a lot to be said for devolving decision-making and allowing consumers to have greater control over their lives. Massive government consolidation is hardly conducive to enabling individual liberties. And unless localities are bypassed altogether, they will doubtless retain some capacity to delay the construction of new dwellings. Yet probably the most damning objection to this initiative is that it could run roughshod over the idiosyncrasies of local ecological needs. Our ambition is not to plaster the nation with obtrusive housing, but rather to stimulate supply within a framework that gives a strong voice to municipal preferences. A centralized zoning agency might only contribute to heightened acrimony with little tangible impact on supply.

In light of the above, we would not advocate a top-down approach. We do, however, believe that there is a role for State-based provision of model zoning codes (which could be adopted voluntarily by councils), and a call for distributing more information about the most efficient ways in which to deal with the legal complexities that plague the planning process. Few would contest the claim that a simplified set of ordinances apropos new construction could significantly improve the welfare of all constituents. (The NSW and Queensland Government’s recent endeavours in this area provide promising precedents.) It does, nonetheless, seem somewhat foolish to try to micro-manage each suburb’s zoning protocols from Canberra!

An alternative tactic might be to maintain the status quo and allow localities to determine dwelling dispersion, while allocating each ‘targets’ for new supply (see the flow chart below). In principle, individual suburbs could be given a quota of permits for a fixed, say, 12 month, period, which would be based on the size and density of their current housing stock, environmental considerations, and relative prices. Expensive regions typified by low concentrations would face commensurately high quotas (think Bellevue Hill or Toorak). This is motivated by the standard economic argument that rising prices reflect excess demand. Our goal is not to bring unwanted units to market, but simply to satisfy the aspirations of Australian households. As such, current prices are a critical guide to understanding where demand exists. The targets could be enforced by linking them to State and Federal Government funding. Municipalities that fail to expand supply in line with their mandated objectives would experience cuts in their fiscal aid. Equally, proactive councils that manage to boost the stock of new homes would be rewarded via more generous funding.

One obvious attraction of this approach is that local administrators retain control over urban planning policy. At the same time, it also instils powerful incentives to dissuade decision-makers from insidiously exploiting land release programs and zoning laws so as to constrain supply and maximise the prices of existing properties Execution issues could nevertheless arise. First, will the system be based on the issuance of permits or actual units built? Since we are hoping to augment supply, not the number of new permits, it makes sense to utilize the latter as the final measure. Yet in the early days it might be more appropriate to focus on accelerating the approval process by monitoring the quantum of permits passed. Second, what requirements will there be with respect to the kinds of dwellings built? Affordable housing advocates would almost certainly lobby for low priced properties. We would, however, advise against dictating to local authorities—fwhere practicable, power should remain with the people. Having said that, it might be worthwhile stipulating two constraints:

1. A minimum floor size area based on recent construction in the region. We want to ensure that councils do not ‘game’ the system by building units that are too small for the current market; and

2. A minimum number of single-family detached homes. Communities should not be allowed to meet their targets by simply erecting one large, skyscraper. Again, this number (or, more accurately, the smallest proportion of detached units to overall supply) could be conditioned on construction experience in the locality.


Third, should State Governments oblige councils to develop properties in specific areas? No. We think it is best to let the neighbourhoods themselves decide where to build. Finally, will the targets condition on the number of applications actually submitted? Yes, when setting quotas, authorities should take into account developer demand.

While this sounds fine in theory, how will it work in practice? In the beginning, communities will have to put a lot of thought towards identifying those districts in which they are willing to decrease dispersion, balancing the costs of new development against the social gains derived from expanding supply. Increasing densities around commercial areas would seem like a natural way in which to make affordable housing available. Along similar lines, producing single-family detached homes in a few focused locales could make a lot of sense. At the end of the day, it will be incumbent on councils to craft a vision of their region’s future urban structure.

One issue that will undoubtedly exercise the minds of policymakers is how best to handle those residents who are adversely affected by the new construction. This is, after all, just a microcosm of the wider problem associated with NIMBYism. Occupiers situated in close proximity to the development should certainly be compensated for any inconvenience caused. But where will the money come from? Well, although our scheme encourages municipalities to expand the supply of housing, it does not advocate the complete abolition of impact fees on development. Hence, as long as councils are able to satisfy their building quotas, they should feel free to tax the relevant participants where appropriate. These charges could then be used to cover the social costs of new construction, and in particular, to recompense dwellers for any complications that come to pass.

A more sophisticated approach might be to pool the funds raised through impact fees and use them to establish a house price ‘insurance’ program for affected residents. Economists have long recognized the grave financial risks implicit in the household’s real estate investment (see Caplin and Joye (2002d)). In spite of this, there are few practical proposals for creating markets to diversify away the principal threats to our standard of living. It is, for instance, far more likely that a property will decline in value owing to unfavourable economic conditions than it will burn down. And yet whereas there is a sizeable industry dedicated to insuring the home against physical damage, there remains virtually no way for households to hedge the risk of declines in the value of their real estate holdings (see also Shiller (1993)).

Source: Joye et al (2003) (Click to enlarge)

But relief may be closer than we think. In the US, there is a nascent ‘equity assurance’ movement that attempts to offer exactly this service. These schemes have been successfully deployed in several urban areas to stem the tide of middle class flight, restore home owner confidence in the local housing market, and revitalize transitional communities by both retaining and attracting dwellers (see Hersch (2001)). While each program has its own peculiarities, the fundamental objective is to develop vehicles through which households can eliminate a large proportion of any future price depreciation.

There is no reason why Australian councils could not offer similar products (through private intermediaries) to residents troubled by the notion that new development detracts from the value of their properties. Indeed, we would be happy to work with municipalities to design such schemes. The contractual structure might look something like this: if the value of the occupier’s home did not increase by an amount that it would have in the event that the construction had not taken place (as measured by a regional house price index), the insurer undertakes to pay the owner the difference at the time they decide to sell. Upon receipt of payment, succeeding households have no further claims with respect to the effects of the development on that specific property. Here it is instructive to highlight the divergent implications of cash or in-kind compensation (e.g., corporate contributions to, say, a neighbourhood park) and plain-vanilla insurance. While both are directed at alleviating the angst of residents, they have different repercussions. When householders accept compensation, they still bear the burden of the downside risk invoked by the development. Conversely, insurance is a contingent claim that helps to protect home owners from aversive future outcomes—if the construction has no effect, payments will not be made. An equity assurance program should therefore be more effective in allaying the fears of NIMBYs, since their troubles are typically a reflection of uncertainties associated with ‘potential’ price paths. The key decision node for the developer will then be: do the adverse consequences of the construction outweigh the present value of the prospective profits they hope to realise (see also Fischel (2001))?

On a related note, a futures markets based on house price indices has already been established by the Chicago Board of Trade in the US. Similar efforts are underway here in Australia. It suffices to say that these projects hint at an exciting alternative reality, in which home owners will be able to equitise the major risks to their standard of living by cost-effectively trading claims (or derivatives therein) on real estate equity.

This article derives from Part Four of the 2003 Prime Minister’s Home Ownership Task Force Report, entitled “Innovative Approaches to Reducing the Costs of Home Ownership”, which was authored by Joye, Caplin, Glaeser, Butt and Kuczynski.