In recent decades, house prices in many major cities have become astronomical by almost any standard. In Canada, for example, they have tripled since 1999. Toronto has taken the lead from Vancouver, reporting in early 2017 an annual gain of about a third. How did this happen?
According to a 2017 report from the Toronto Real Estate Board: “Key drivers of record home sales included population growth, low mortgage rates, low unemployment and above-inflation economic growth.” But the latest census figures actually show the city is growing at its slowest rate in 40 years, while wages are increasing at the slowest rate in 20. Mortgage rates are indeed low, but consumer debt is also at an all-time high.
Other oft-cited reasons include foreign investors, speculators, Canada being an awesome place to live, herd behaviour, Toronto being like New York, planning restrictions on new houses, and so on. It has even been suggested that the reason is lack of supply, because no one can afford to move. Strange, given that if you do sell your home, you are rich and can afford all sorts of things – including a move.
But while some of these may be contributing factors, the most basic reason is much simpler: it is because there is a lot of money. And why is there a lot of money? Because houses are expensive. If this sounds like a magic trick, that’s because it is.
The levitation trick
One of the most famous tricks in the world of magic is the levitation trick, in which a magician makes it look as if an object or person is floating in the air, defying the force of gravity. I don’t think I’m giving too much away when I say that the levitation is in fact an illusion, and something mechanical is needed to make it happen. But just as important is the magician’s patter – his ability to distract the audience from what is going on by creating a different narrative.
The great 19th-century French magician Jean-Eugène Robert-Houdin, for example, performed an ‘ethereal suspension’, where he claimed that the incredible properties of the newly discovered substance ether could make his son float in the air. The city of Paris was enthralled by this mysterious new material, and so his Parisian audience was willing to believe it.
What does this have to do with house prices? Well, this is another trick performed for money – only here, money plays a more important role. We (or, actually, economists) tend to treat money as an inert thing, a kind of placeholder with no special properties – but it has a magical power of its own.
Money supply is primarily created and controlled by private banks, not the government or central bank
Most people know that printing too much money leads to price inflation. Less well known – the Bank of England, for example, only released a paper explaining it in 2014 – is the fact that the money supply is primarily created and controlled not by the government or the central bank, but by private banks (the magician in this story). They create this money by issuing loans, and most of these loans are used today for residential real estate.
Conjuring a magic coin
When you apply to a bank for a mortgage, they don’t lend you money that they actually have – they just make up brand new funds. As Germany’s Bundesbank noted in a 2017 report: “This refutes a popular misconception that banks act simply as intermediaries at the time of lending – i.e. that banks can only grant credit using funds placed with them previously as deposits by other customers.”
Because the loans are backed by real assets, such as a customer’s house, it seems the two sides cancel one another out, and nothing has changed. Except it has, because now there is more money in the economy. While you weren’t watching, the bank has sneaked in new coin and increased the money supply.
As Adair Turner noted: “Economic textbooks and academic papers typically describe how banks take deposits from savers and lend the money on to borrowers. But as a description of what banks actually do, this is severely inadequate. In fact, they create credit money and purchasing power. The consequences of this are profound: the amount of private credit and money that they can create is potentially infinite.”
The more money there is, the higher house prices (and bank profits) can go – which explains why the Teranet house price index and the broad money supply have advanced in lockstep, each tripling since the index began in 1999. The same self-reinforcing feedback loop has driven asset price bubbles throughout financial history.
Banks do not, of course, want to draw attention to their ability to create “potentially infinite” funds in this way, which may explain why, as Turner noted, it was largely “written out of the script of modern macro-economics”.
So, to understand why house prices can continue to climb year after year, in a remarkable act of levitation that never fails to amaze and impress, you have to ignore the patter coming from banks, economists (many of whom work for banks anyway), realtors and so on. Instead, you need to focus on the action behind the scenes. It’s all a banking trick. Of course, this also suggests an obvious way to make houses more affordable: just reduce the amount of money. And the easiest way to do this is to lower the price of houses.
As with any magic trick, the effect relies on the audience’s confidence, which by this point is probably rather easily shattered. In Toronto, for example, the provincial government recently introduced a number of measures, including a tax on foreign buyers. The collapse of the alternative lender Home Capital Group has also highlighted the fragility of many of the loans being made. Any of these developments – or some other factor, such as a change in interest rates – could be enough to reduce confidence and change the direction. At this point, the process can again become self-reinforcing, as all that money creation goes into reverse – at least, until the next time.