October 17, 2016
If you give people tax breaks to buy homes, you cause house prices to risePosted in Sunday Business Post · 110 comments ·
If I were setting the ordinary level Leaving Cert economics paper my first question, an easy one, to get the students started would be a simple one about supply and demand. It would go something like this:
A country is experiencing a shortage of supply of starter houses; builders say they can’t make enough profit at the existing prices to make it worth building. What would happen if the government gave people a tax break to help them buy houses? Would the price of houses go up or down? Please demonstrate your answer with basic economic charts of supply and demand.
The right answer would centre on the fact that the demand curve for houses would shift outwards straight away, driving up prices immediately. Supply might respond in time, but the impact of such a move would be to definitely drive all prices of starter homes upwards.
A good ordinary level economics student should get this.
For some reason the public servants in the Department of Finance, didn’t figure this out. Or maybe they don’t care? It is difficult to fathom. Now we are talking here about basic stuff. This is one of the basic laws of supply and demand. It isn’t complex. It is basic microeconomics.
The reason I am singling out these mandarins rather than politicians is because politicians do what they have to do to get elected. The politician sees the “first time buyer” as a homogenous voting block and he or she wants to be sure of their vote next time. That’s fair enough. In a PR system, the margins between winning and losing a seat are so wafer thin that the politician has a serious career interest in being seen to be the friend of what is perceived as a block. That’s the economic weakness of democracy, but I suppose it is also its political strength at the same time.
However, the economist in the Department of Finance, the mandarin who doesn’t have to face the electoral music every few years, knows better. Not only does he know that the first time buyers are not a block, but he will also surely know the first fundamental rule of macroeconomics, which is known as the paradox of aggregation.
This rule in plain English means that what is good for the individual is not always good for the collective.
So take the block of first time buyers. Yes, they are all individuals but they compete with each other in the market for houses. We also know that it is a market for scarce houses.
The basic rule of macroeconomics says that what is good for the individual is not always good for the collective. This means that a tax break for the individual is great for her and gives her a leg up in the market, so long as no other first time buyer avails of the same tax break. When all the rest of the first time buyers avail of the same tax break it simply cancels out the individual advantage and forces everyone to compete with each other at higher prices if the market is tight.
The same thing happens when the market is slack and faced with too many houses and broken balance sheets like it was in 2008. Banks would tell the individual who had too much debt to sell his extra apartment to fix his balance sheet. This was good advice so long as the bank didn’t tell every bankrupt the same thing because if they did (which they did) everyone would sell at the same time and prices would just fall and the seller would be faced with the same problem of trying to sell but at lower prices.
The paradox of aggregation is perhaps the simplest rule of macroeconomics.
Now when you look at the budget this week, which must have been signed off by the Department of Finance, we see a total absence of any understanding of the basics of both microeconomics, which involve the laws of supply and demand, and of the basics of macroeconomics, which centres on the, sometimes counterintuitive, paradox of aggregation.
This is also galling because these are the people who spouted the “soft landing” mantra a few years ago and were rewarded for that failure with promotions and foreign tax-free sinecures.
Indeed, when the public sector goes for the big pay deals to compensate them for the fact that the economy is growing again, these top mandarins – the faceless nomenklatura of the country – will be paid handsomely.
They should have explained the basic laws of economics to the politicians. These people are the permanent government. They will be around when the sweating politician, being grilled under the TV lights, is well gone. The mandarins will still be drawing gold-plated “defined benefit” pensions when the punters in the private sector will have to deal with the fact that at interest rates of zero, the chances are that their “defined contribution” pensions will not provide for them.
I have no problem with paying civil servants well. But I do have a problem with rewarding stupidity. These mandarins are trained economists who should explain to politicians what is likely to happen in a dysfunctional housing market when you introduce tax breaks for first time buyers.
On Friday, it was widely reported that many developers automatically increased the price of starter homes in response to the budget. They didn’t even wait for the Finance Bill to be enacted, prices all over the country simply jumped overnight.
This is exactly what I would have expected a decent ordinary level Leaving Cert economics student to have replied in answer to the opening question.