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Author: Jan Nieuwenhuijs
Adjusted for inflation, house prices in Amsterdam have never been as high as they are now. In addition to low interest rates, the cause of rapidly rising prices lies in a feedback cycle between banks and consumers who have become addicted to mortgages and ever-higher house prices.
With the credit crunch—caused by a real estate bubble—still fresh in our minds, house prices in many developed economies are currently rising at a rapid pace. Record pace. In the Netherlands, house prices rose by 19% compared to the previous year.
Some economists think that house prices in Amsterdam—of which I have been able to get the longest-running index—have been overvalued since 2020, based on rents and interest rates. Other economists point to policy changes that have been introduced in the West over the past few decades, and a "House Price Financing Feedback Cycle" and banks have become addicted to mortgages, driving up house prices and making consumption increasingly dependent on real estate profits. As banks lend less to productive firms as a result of this trend, the driving force of economies is weakened.
A number of building blocks of capitalism were invented in Amsterdam. At the end of the 16th century, the Dutch embarked on trading expeditions by sea to Asia. Around 1600 there were six young "East Indies" companies that sailed from Dutch ports. In order to combat Spanish and Portuguese competition, and not to compete with each other, the six existing companies were merged into one: the Dutch East India Company (VOC for short).
The VOC was officially founded in 1602 and was the first public limited company whose shares were traded on the first stock exchange. Money from all over Europe poured into the Netherlands. Due to the extraordinary success of the VOC, Amsterdam had to expand, and did so by digging three canals around the medieval city center: the Herengracht, Keizersgracht, and Prinsengracht.
The transaction prices of real estate on the Herengracht have been accurately tracked over the centuries. In 1997, the Dutch economist Piet Eichholtz made a price index of houses on the Herengracht with a constant quality from 1628 to 1973. This was the birth of the Herengracht Index. Eichholtz's initial study found that real house prices (adjusted for inflation) gradually changed over time, but in 1973 were fairly similar to prices in 1628.
Source: A Long Run House Price Index: The Herengracht Index, 1628-1973, by Piet M. A. Eichholtz. Wars, plague epidemics, trade competition, and financial crises have all had an impact on house prices, but relatively little compared to what would happen after 1995.
Eichholtz et al Published in 2020 an update of historic house prices in Amsterdam. For this publication, Eichholtz collected a deeper set of data, beginning in 1620 and encompassing houses from a wider area. Although the figures show that prices started to rise sharply from the 1990s onwards, the conclusion of the article was that the housing market did not enter a bubble until 2019, based on rents and interest rates.
Recently, a colleague of Eichholtz's, Matthijs Korevaar, was kind enough to send me their data up to and including September 2021. In an email, he wrote that after 2019, prices have risen so fast that their model now suggests that Amsterdam real estate is overvalued. Below you will find the graph of Amsterdam real house prices from 1620 to September 2021.
Index of Amsterdam real house prices (return) Charlie Morris)
What happened in the 1990s that caused house prices to rise far above those seen during the Golden Age and the "second Golden Age" (in the late 19th century)? To better understand the housing market, I consulted the books of an economist who specializes in land, houses and banking: Josh Ryan-Collins.
According to Ryan-Collins, there have been two major developments in the housing market since the beginning of the 20th century: a change in land taxes and financial deregulation. Although he has mainly studied Anglo-Saxon economies, I have compared his findings with the Netherlands. These turned out to be similar.
Classical economists, such as Adam Smith and John Stuart Mill, considered land to be a capital asset that cannot be compared to other capital goods, mainly because the supply of land is limited and land cannot be moved. If the demand for land increases, the price rises without creating more supply. When there is economic growth, the value of land—on which houses sit—will increase disproportionately relative to goods and services (even if the owner of the land played no role in creating that value). Smith and Mill's solution was to tax land more than labor or profit. Indeed, in the 18th and 19th centuries, land taxes were an important source of revenue in the United States and Europe.
Then came the neoclassical economists who rejected the above-mentioned theories of land. This led to a shift from land tax to income tax in the 20th century. So it became more attractive to own a house as an investment property. The only thing missing was a way to finance real estate.
From the 1930s through the 1970s, governments in most developed economies imposed credit regulation on banks, restricting the granting of mortgages. Banks prefer mortgage credit to corporate credit, because the former carries less risk. Usually, the house purchased with a mortgage serves as collateral for the loan. If the borrower goes bankrupt, the bank can seize the collateral and the damage will be limited.
When lending to a company, there may be low-quality collateral or even no collateral. For society, however, providing credit to productive businesses is essential, as it ensures sustainable economic growth and the additional income to repay debts. But credit regulation has gradually been dismantled, with the result that in 1995 bank mortgage credit overtook non-mortgage credit. The mortgage revolution was a fact.
Lending in eighteen developed economies. Credit volumes as a percentage of GDP are an unweighted average.
A bank creates money out of thin air when it provides credit. So when banks provide mortgages, the money supply is increased, but the money is spent on a limited number of houses. The money supply is elastic, while the supply of houses inelastic is. No wonder house prices rose in the 90s. Then the feedback cycle kicked in: higher house prices created more demand for mortgages, which further pushed prices up, resulting in more demand for mortgages, and so on.
Mortgage securitization, which took off in the 1990s, also contributed to "the cycle." Securitisation allows banks to bundle mortgages and package them in a Mortgage Backed Security (MBS). An illiquid asset (mortgage) is converted into a liquid asset (MBS) that can be sold to, for example, a pension fund. Banks make money from selling MBSs, and when the effects are off their balance sheets, more room is freed up for issuing new mortgages.
Finally, the capital controls that were lifted after the collapse of Bretton Woods in 1971 meant that banks were no longer dependent on domestic deposits for their funding. Banks were given access to international money markets, where they could raise additional financing for home loans.
Rising real estate prices lead to a higher ratio between housing costs and incomes, and thus to less consumer spending. This loss of spending in the "house-price-financing feedback economy" is offset by the "wealth" generated by increased house prices. For example, people who have equity on their real estate will spend more because they feel richer (Wealth Effect), or take out a second mortgage to buy a boat. Others make a profit by speculating in real estate. But spending can only be sustained as long as the cycle continues.
To sustain this cycle, rising house prices and more and more debt are needed. The unsustainable debt spiral will continue as long as central banks cut interest rates. In my opinion, the above looks like a pyramid scheme and the housing market is a bubble. Although I'm not sure how long this situation will last and how the bubble will burst. Perhaps nominal house prices will fall, perhaps inflation will rise to such an extent that real house prices will return to their long-term average. A big problem with falling nominal prices is that it can overturn the banking system, something central banks want to avoid, as banks have huge exposure to mortgages.
I want to emphasize that not every (developed) economy has the same housing market. Nor does the mortgage debt go up in a straight line. After the credit crisis in 2008, house prices and mortgage debt fell in many economies. In response to the crisis, governments came to the rescue to bail out banks and prop up the economy—increasing public debt. The housing bubble was not allowed to deflate completely. Interest rates then reached zero, real interest rates became negative, and the cycle was revived. House prices are resuming their rise.
House prices developed economies (Source: OECD)
Furthermore, an academic article ("More Mortgages, Lower Growth?") from 2016 by Dirk Bezemer et al:
In newly collected data on 46 economies in the period 1990-2011, we show that financial development since 1990 has been mainly due to the growth of lending to real estate and other asset markets, which have a negative growth coefficient. ... We find positive growth effects for credit flows to non-financial companies, but not for credit flows from mortgages and other asset markets. ...
Not only has the mortgage revolution displaced lending to productive businesses, but lending to mortgages is also having a negative impact on growth.
Could it be that the mortgage revolution, which is squeezing economic growth, combined with a fiat international monetary system that allows unlimited levels of debt, has produced the greatest debt trap in history?
Finally, in the Netherlands, and I suspect elsewhere as well, the most frequently mentioned solution to unaffordable housing is to simply build more houses. This approach fails, because banks can always print money faster than anyone else can build houses. The solution lies on the demand side, not the supply side.
This article originally appeared on The Gold Observer
