25 May 2014

Supply, Demand and the Housing "Market"

For many reasons the conventional story of supply and demand does not fit the housing market. It is a market only in the sense that there are some people selling and some people buying. otherwise talking about a market in housing is likely to mislead.

Nonetheless we can use the old theory to gain insights. I tried to suggest on Twitter a way of looking at the interaction of supply and demand which better fits the facts than the textbook model. I made a mess of it so here is an explanation in more than 140 characters.

My target here is the belief that house prices are rising because demand outstrips supply.

Firstly, the textbook story looks like figure 1.
Figure 1
Here we see that supply is lower than demand. Theory says that in these conditions the price should rise to the equilibrium. So far so good. the problem is that this model explains high prices not rising prices. at best it explains why prices have risen but not why they continue to rise.

To deal with continually rising prices we need to assume that the demand curve is moving rightward faster than the supply curve. This is where the second problem comes in: house-building is stronger when prices are rising.  During the last boom, new housing units were added faster than new household formation. Increasing supply, in this model, means shifting the supply curve to the right, which should lower prices; the opposite happened.

A more realistic model would recognise that the supply curve is nearly vertical, at least in the short run. However for an increase in supply to coincide with higher prices we need an upward sloping demand curve. That gives a model like figure 2.
Figure 2
Notice that supply is still lower than demand at the assumed current price. In the conventional model when this occurs some buyers are willing to pay more to secure their purchase. Thus prices rise until they reach the market clearing equilibrium. In this model too prices rise, but they are rising away from the equilibrium. They just keep going.

To understand why, we need to find a reason why rising prices attract buyers into the market. perhaps people feel the need to buy now before prices rise further. Perhaps they believe that rising prices are making house owners richer and they want to join in. A combination of anxiety at missing the chance to own and the desire to own an appreciating asset are enough. Fear and greed are powerful incentives.

The gap between supply and demand can explain high prices, but the shape of the demand curve explains the dynamic of increasing prices.

30 April 2014

Mr Osborne, K21C and the 40%

Are we heading back to 1890s levels of inequality? According to Professeur Piketty we are but with one interesting difference. The top 10%, by wealth, now command around 60% of all wealth in European countries. So who has the rest? Not the bottom 50% who have at most 5-10%. That leaves the 40% in the middle who Prof. Piketty says have a third to a quarter of the wealth.

Where the 19th century elite had all the wealth and inheritance game to themselves there is now a level of capital ownership beyond the top 10% and into the next 40%.  The remaining 50% have as little as ever. He sees this as  a new "patrimonial middle class" who will leave substantial bequests to their descendants. 

His analysis of the French data  is not easy to summarise, but here goes. He estimates the proportion of people born in each decade who will inherit more than the average lifetime earnings of the bottom 50%. For those born in the 50s some 5% can expect a significant inheritance. This is already higher than the cohort born in the 1920s where barely 2% would inherit above his benchmark. However 12% of the cohort born in the 70s can look forward to inheriting at this level, which is higher than the proportion in the 19th century.

I find this intriguing because of its political significance. I wonder to what extent this shift results from a deliberate political project to create a larger segment of society with an interest in conserving the status quo. I have in mind Mrs Thatcher's drive to extend home ownership in the 1980. The privatisation of state assets was also intended to create a permanent base of broader share ownership. Remember her vision of a property owning democracy with wealth cascading through the generations. 

Was this a deliberate strategy to extend the middle class, creating a large voting bloc whose interests were aligned with the rich? More recently Mr Osborne has added to this dynamic with his changes to the pension rules.

There is a hypothesis in economics which says that people save in order to smooth consumption across their lives. So young people borrow to pay for education and buy a house. In their middle years they pay down their debts and build up savings. In later life their savings fund their retirement. If this view is correct then savings would be used up in retirement with nothing left to pass on. Indeed the mechanism to do this is the purchase of an annuity; savings become an income for life.

I don't imagine that increasing the patrimonial middle class was Mr Osborne's primary motivation for abolishing automatic annuity purchases. On the other hand, I can see how it continues the shaping of a conservative leaning electorate. 

I remember too that in opposition Mr Osborne achieved a major success when he made inheritance tax a political issue. He is credited with scaring the Labour government into abandoning plans for a general election in 2007. He uncovered then the salience of inheritance as a political motivator.

I offer this as somewhat speculative thoughts inspired by reading K21CYou could argue that the same shift is happening in countries that were spared Thatcherism. Nevertheless I think there is something here.

28 April 2014

K21C and the Boiled Frog

The tax man's taken all my dough,
And left me in my stately home,
I came of age in the 70s and so my formative experience of politics was during the various Wilson administrations and their interruption by Mr Heath. In those days we took for granted that inherited wealth was a thing of the past. Great estates were sold off to pay death duty, stately homes were donated to the National Trust or turned into safari parks and the Kinks sang Sunny Afternoon.
And I can't sail my yacht,
He's taken everything I've got,
We had progressive taxation, governments that saw redistribution as part of their role, and a belief that inequality would continue to diminish. Conspicuous wealth was something we read about in historical novels.

To people of my generation M. Piketty's Capital in the Twenty-First Centuryis a revelation. I feel something like the infamous frog sitting in a pot on a lit stove. I've been aware of the rising temperature for most of my adult life, I've felt the growing discomfort but, at some deep level, I believed that the Thatcher to Blair period was the aberration. I've kept the hope alive that soon the temperature would cool and we would get back to a meritocratic, egalitarian and democratic direction.

M. Piketty has shown that the reverse is true. The postwar period, the 50s to the 70s, was the exception. Inequality of income fell during the first half of the 20th century due to wars and the great depression. The income of the top 1% in the UK was around 17% of national income on the eve of WWII. Wartime restrictions and the post war policies saw that level fall to 8% in the 60s and 6% in the 70s. Since then the share of the top 1% has risen to 14%.

Inequality of wealth also shows a pattern of falling from WWI until the 1970s and beginning to rise from then.The top 10% went from over 90% to 60%and now back to 70%. The rise looks less dramatic than for income. Income inequality is being driven by the exessive pay going to senior managers, what M. Piketty calls the rise of the supermanagers. But there is more; the concentration of wealth also requires inheritance.

Robert Peston pointed out in his book, Who Runs Britain?that today's business oligarchs will leave their fortunes to future generations who may not have the talents of their patriarchs but will have the power that wealth brings to protect their interests. M. Piketty provides some numbers on the flow of inheritance which again shows a u-shape with decline from 1910 until the 1970s followed by a small rise.

His explanation for the tendency of capitalism to lead to ever greater concentration of wealth is summarised in his inequality: r>g. If the rate of return on capital is greater than the growth rate of the economy, then the rich have the ability to add to their wealth faster than national income expands. The very rich are most favoured because they can achieve higher returns on their fortunes and because they spend only a small proportion of their income from capital.

As a mater of fact (but not logical necessity) r has always been higher than g. It is only when taxation of capital income is taken into account that g outstrips r. Again this is a 20th century phenomenon; tax competition and lower population growth make it unlikely to continue into the future.

So that, in a British context, is the political hope for M. Piketty's contribution: to alert us frogs to what is happening. It is time to hop out of the pot and put equality back in the centre of the political discourse.

25 April 2014

The Pleasure of Piketty

Very occasionally there is a book which is a joy to read. Even more rare are the occasions when the book is from the non-fiction shelf. I might be unusual in treating economics books as recreation, but Thomas Piketty's Capital in the Twenty-First Centuryis a delight.

The book has two qualities which appeal to me and make it one of the most enjoyable reading experiences I've had outside of science fiction. Firstly, this is study built on evidence. It is not a theoretical text but puts its empiricism up front. Thomas Piketty has assembled datasets, with the help of collaborators and followers, which allow him to look at wealth, income and their distribution over long periods of time and across various, mostly developed, countries. The data is imperfect and he openly discussed the limitations this puts on the ability to draw conclusions, which lends a pleasing honesty to the narrative.

The second great pleasure in this book are the number of fresh ideas the evidence allows him to present. each chapter exposes new insights into the various questions, how much wealth countries accumulate, how income is distributed and how wealth is concentrated. After reading this book the way we understand and think about inequality is completely transformed. The fresh insights just keep coming page after page, chapter after chapter.


Here are a few examples of his key insights.
  • In the 19th century European countries had accumulated wealth (or capital) equal to around seven years of national income. That fell during the period of the world wars and the great depression to 2 to 3 times annual income in the 1950s. But it is on the rise again with capital around 4 to 6 times income now.
  • As the level of relative wealth fell so too did the income from capital which accrued to the richest individuals. For this reason as well as egalitarian post-war policies, income inequality fell but began rising again from the 1980s.
  • Wealth inequality also fell from a high point before WWI (when the top 10% owned 90% of the capital in Europe and 80% in the US). It too has been rising since the 1980s.
  • Inequality of wealth has not reached its previous level in part because the second 40% now claims a greater share of wealth, giving rise to what he calls a patrimonial middle class. (I will return, as M. Piketty would say, to this point.)
The book exposes some of the dynamics behind the accumulation of capital and rising inequality. The rate of return on capital is usually (but not necessarily) higher than the rate of growth (r>g). As a consequence, those fortunate enough to own wealth are able to add to the stock of capital and so increase the concentration of wealth.

He argues that the shocks of the world wars and the great depression caused the capital/income ratio to fall from a "normal" level to which it is now returning. That normal level is given by the stability condition β=s/g, where β is the ratio of capital to income, s the saving rate and g the growth rate. So a saving rate of 10% and a growth rate of 1.5% gives a capital around 7 times income.

One conclusion from all this is that the post war period when inequality seemed to be consigned to history was an exceptional period. It is also the time when my generation were forming their perceptions of the world and its political reality. It seems our ideas are falsified by taking a wider historical perspective. (Another point to which I will return).

There is a great deal more in the evidence and analysis in the book than I am able to set out now. There will be much more to say on this book and inspired by its evidence and conclusion. For myself, I am still trying to reconcile the algebra, which I feel he offers more as heuristic than as a model.

This conversation is only just beginning.

I'm Back

I'm back. My long sabbatical is ended and I have returned to my spiritual home at Equals.

I was tempted to break the retreat by some of the big events of the last few months. The passing of Nelson Mandela seemed to be an opportunity to comment on the strange arc of his life as the man who led the ANC to take up arms and then drew on its non-violent tradition with his leadership of reconciliation when freedom arrived. The death of Tony Benn too was a moment when I was tempted. I felt too little of the appreciations written of his life understood that Parliament was his driving passion. He saw in parliamentary democracy the only means of creating a more egalitarian society. But I resisted.

I seem to be returning at the point where equality has returned to the political agenda. Last year there was a bit of  buzz around a French economics book. I waited for the translation and now find that everyone is talking about it. His tour promoting the book in the US (it is translated into American English) has set fire to American political discourse. So given that equality is the theme of this blog I suppose that is where I should start.