Most Houses are Not Productive for the Economy

We’re still in Australian Small-Cap Investigator mode today.

If you happen to be a subscriber to Australian Small-Cap Investigator I should let you know that the February issue will be released on Monday. If you’re not a subscriber then click here to subscribe.

Anyway, back to Money Morning…

Yesterday I wrote to you about mailbags bulging at the seams. After yesterday’s Money Morning went out, the mailbag started to bulge with responses.

To paraphrase most of the responses we received, “How would the free market work if an uninsured person was murdered/injured/unable to afford schooling? Who would pay for the investigation/medical bills/school fees?”

As we’re in a rush today we’ll hold some of those excellent questions over until next week. We’re glad some readers have asked them. As we’ve noted before the approach we take when reading anything in the news is to immediately disbelieve it and then work through the argument to see if it’s correct.

We do that even with people we know we generally agree with.

As a reader of Money Morning it’s something you should also do with these newsletters.

But quickly getting back to the question above, what I will say is that it isn’t as complicated as it seems. All it requires is to set aside the conventional thinking and then consider how markets really work.

Look, I’m not surprised free markets get a bad press. Governments and special interest groups have done a pretty good job of demonising the free market. So it’s not surprising that we received this comment yesterday as part of a longer email to the Money Morning mailbag:

“In Britain there was pretty much a free market for slaves for sugar production that only started to succumb to ethical pressure when the economics started to look shaky in the face of improved growing and processing methods.”

You can see how much the idea of free markets and freedom (it’s the same thing by the way) has been so misrepresented by governments that people assume that free markets equal slavery!

We think the term a “free market for slaves” could be an oxymoron, but we’ll let those that are more educated than your editor work that one out.

The very essence of free markets and freedom is that enforced slavery would be illegal as it is an infringement on individual freedom. Forcing someone to do something against their will is the realm of governments (compulsory voting, taxation, private health insurance, etc) not the free market.

Anyway, as I say we’ll cover all of that in more detail next week…

Your editor almost had a coronary yesterday afternoon as we belatedly flicked through the tiresome Australian Financial Review (AFR), “‘Home loan bias bad for economy’”.

And it was in quotes which indicated the headline was a direct quote from someone. Sure enough it was. But the real surprise was who it was that said it – Joseph Healy, National Australia Bank’s (NAB) head of business banking.

He was quoted as saying:

“A banking system which allocates capital away from the most productive areas of the economy – business – is ultimately bad for growth, bad for competition, bad for jobs, bad for business and in the end bad for Australia.”

Gadzooks! We think we’ve just found a hero in banking. Although he’ll need to keep his head down. Because we’re sure NAB’s head of home lending (if such a position exists) will be throwing spears and tomatoes at Healy for daring to say such a thing.

Doesn’t Healy realise that it’s too late to issue the warning? All we can really do now is cover our ears. Like the kid in the background in the cafe scene in North By Northwest, who knows the loud bang is coming just before Eva Marie Saint pulls the trigger on Cary Grant, so he sticks his fingers in his ears to soften the noise.

The trouble is, the shot is still fired, that can’t be stopped – it’s in the script after all! And it’s the same with the housing bust. The script is written, all you can do is cover your ears and hope the shot misses you.

But it’s good to see a mainstream banker tell the world what we’ve said all along, most houses are not productive for the economy.

Sure, to a degree they are, in that they provide a roof over someone’s head. But there’s a limit to how much of a house is productive and how much of a house is unproductive and a waste.

We’ll be honest, we’re still inclined to think that 100% of a house in unproductive in terms of its usefulness to an economy. Once it’s built it’s built. That’s it. It doesn’t contribute anything else to the economy apart from providing shelter.

That’s what makes it a consumer item.

But let’s for a moment concede that a house is always productive – as the property spruikers claim. If you’re looking at a one-bedroom house that has one occupant, and the house also has a kitchen, bathroom, and lounge room, it could be argued that house is productive as it provides shelter for the resident.

But how about if you add another bedroom? There’s still only one person living there. And what about a second lounge room? A third bedroom? A fourth bedroom? A second bathroom? A third lounge room? A third bathroom? A laundry? Etc…

Yet there is still only one person living in the house. Is that house still productive? Is it still a useful allocation of resources?

If the house was at its most productive when it was a one bedroom home, then surely it has become less productive the more rooms are added, unless there is an increase in occupants.

Look, we’ve taken an extreme example there. But our guess is that well over 50% of the homes in Australia our underutilised. In other words they have more capacity than they use. Which means they’ve sucked resources away from other areas of the economy.

Let’s use a business as a comparison. According to Mr. Healy businesses are productive. We’re sure that’s the case for most of them. But some are not.

Would we consider a business to be productive or fully utilising its capacity if it had invested $1 million in machinery that could make 1,000 grommets each day, when the machine was only actually making 300 grommets each day?

A rational person would rightly consider that the business had overcapitalised. They don’t need a 1,000 a day grommet making machine when a 500 a day grommet making machine that was half the cost would have sufficed.

So, we ask, how is it any different for housing? Yet when a homeowner buys a bigger home than they need, only using half of the rooms, that’s somehow seen as a good investment.

The key is in Healy’s other comment:

“I think that one of the little focused-on but absolutely critical questions for our industry and Australia’s policymakers is the extent to which the Basel II capital rules create an economically unhealthy bias towards residential lending and distort capital allocation away from more entrepreneurial and productive sectors of the economy.”

Double Gadzooks! Looks like we need to drop Mr. Healy a line to see if he’d like to make some freelance contributions to Money Morning – for a fee of course.

In other words, yet again, banking regulations that are spruiked as making banks safer are in fact doing the exact opposite. The Basel II rules are helping our dear friends at the Australian banks to pump, pump, pump that housing bubble.

We always hear the argument that housing is productive. Because you can buy it today and sell it at a profit in a few years time. And therefore because it can be resold for a profit, housing is an investment, not a consumer item.

Well, a more convincing argument is that housing is most definitely a consumer item. Because once you’ve bought a house you ‘consume’ it. The house that you re-sell in the future is not the same house that you bought. [Readers voice: What the heck are you talking about?]

Simply put, let’s say you build a house today. You have paid X dollars for a brand new house. However, if you were to sell the house in ten years you aren’t selling a brand new house.

The house you’re selling in ten years is a ten year old house. It isn’t the same as when you bought it. Therefore the house you buy today isn’t the same item that you’re selling in ten years.

That’s what makes it a consumer item and not an investment. Just like the new jumper you buy today isn’t the same as when you sell the jumper on eBay in two years time. No one will pay you the same for it then as you paid for it today.

That’s because you’ve ‘consumed’ it. No one can claim jumpers are an investment.

“Ah, but the land value appreciates,” is the usual response. Maybe it does, maybe it doesn’t. But that doesn’t make housing any less of a consumer item. Furthermore, demolishing a house in order to build a new one is a further misallocation of resources.

The idea that building things to destroy them and then build new things is somehow economic growth is bizarre.

But that is what’s happening in housing. The mindset is that house prices always rise. And that they rise so much you can get away with buying something, destroying it, and building something new and you’ll make even more money.

House prices have only risen in value due to the excessive issuing of credit by the banks. More and more resources and credit is flowing through to an industry that makes hugely expensive consumer items.

While there is nothing inherently wrong with producing consumer items, the problem is that Australians don’t realise they are buying a consumer item. Thanks to the spruikers they are under the false impression that they’re buying an investment.

Hence the housing price bubble. Like the young lad in the movie, we’re waiting with our fingers in our ears. Any moment now…

Cheers.
Kris.

Tagged as: Australian Financial Review, australian small cap investigator, economy, homeowner, houses, housing price bubble, National Australia Bank