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What's really happening when real estate prices get to be unreal?

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My education in economics may be a bit out of date but the principles of how the system works don't change with time, only the details.

I understand that in a free market, prices are set by agreement between buyer and seller. If buyers are prepared to pay a high price for something, the sellers gets the benefit.

The question arises, why have prices for land and houses escalated so much over the last twenty years. This phenomenon is not a uniquely Australian one because the same situation occurs in some parts in the UK and of the USA.

It is, perhaps, not coincidental that banking was deregulated about twenty years ago. Access to loans used to be quite tightly controlled both for businesses and for individuals because banks were required to deposit funds with the Reserve Bank and to hold current assets against a portion of their outstanding liabilities. These regulations were presumably designed to protect lenders against bank failures. When these regulations were abandoned, we lost that protection.

The economic revolution of the last two decades whether it is called "supply side economics", "dry economics" or "economic rationalism" is predicated on a global capital market which is claimed to provide economic growth and increased prosperity for everyone.

It doesn't take a rocket scientist to discover that "everyone" has a very particular meaning in this context. A cynic might conclude that, in today world more than ever before, the rich get richer and the poor get poorer. In fact, at least some of poor are getting richer as well, but at a rate which is a very small fraction of the rate at which the rich are getting richer.

Bank executives who are fired for non-performance don't leave their jobs in penury, they have all been paid obscenely large amounts of money under some kind of incentive bonus scheme which apparently doesn't take failure into account. Workers who have worked faithfully for a company for many years and who have had their jobs declared "unnecessary" by executives who are chasing their performance bonus, are lucky to be paid enough to keep their families fed until they can find another job.

What has all this got to do with real estate prices?

The apparently unlimited access to credit has allowed people to borrow large amounts to buy property as an investment with the only collateral for the loans being the high prices being paid for real estate. Of course, only people with adequate disposable income can do this; the poor are excluded. This is all very well while the market is rising, but should the market fall, the lenders will have to call in loans to cover their exposure and the downward spiral will ensure that the collapse is dramatic.

The truth is that the "value" of an asset is only the use to which the asset can be put. People buy the results of primary production, food, and of secondary production, appliances, because the need them to survive and to carry on their chosen lifestyle. Because there is some breadth to these markets, the prices set between sellers and buyers generally represents a reasonable measure of utility.

If the price of an asset is based solely on a gamble that someone else will pay more for it than you did, perhaps there is an imbalance between price and utility. When this effect comes to dominate an economy as it does today in Australia, the imbalance may well lead to a "correction" which will see lots of "rich" people become poor people.

The sad thing is, that many of those who are pursuing this new Australian dream, owning property as an investment rather than as a place to live, don't seem to understand that they are gambling in a very big way.

Perhaps I have an old fashioned view of the way economies operate. I still believe in the primacy of "real" production as the foundation of our economy and consider that tertiary industry and all its latter day extensions, quaternary industries such as gambling, must be subservient to the generation of "real" wealth by primary and secondary industries. I see all around signs that gambling is a very large and growing industry and I worry that many people don't understand the difference between the real and the ephemeral.

The market for tulips in Holland in the 18th century, which rose to the point where artisans were paying a years income for a single plant because the "market" had valued the things that way and they were determined to get a bit of the action, collapsed when it became unsustainable and many foolish but innocent people became paupers. The notion that it can't happen to me is an illusion.

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Created: 12.10.2004 and last revised 05.11.2004
Author: Robin Chalmers Copyright in all the material on this site is asserted by the author
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