Recent months have seen house prices in Spain rise for the first time in six years, after the housing sector was badly hit by the financial crisis. José García Montalvo writes that one of the most damaging aspects of the crisis in Spain was that the housing bubble experienced during the 2000s was also accompanied by declining productivity. He notes that the underlying picture in the real estate sector remains fragile and that in contrast to previous economic crises in Spain, a revival of the housing market is unlikely to offer a route to economic recovery.
It is well known that one of the culprits of the Spanish economic crisis was the housing sector, as was the case in many other countries such as Ireland and the United States. The size of the Spanish housing bubble was huge: in just a few years the ratio of housing prices over household disposable income doubled from 4 to close to 8. But the worst part of the housing bubble and Spain’s “marvelous decade” was the decreasing productivity of an economy concentrated on building houses, alongside the institutional corruption tied to the development of land and the housing business. In fact, an important part of the current corruption problem in Spain stems from the easy money of the prodigious years of the housing bubble.
From the outset, many pundits tried to explain the Spanish crisis as the result of an international shock. The figure below shows that they are wrong. Economists disagree on almost everything, but there is one point in which we all agree: an economy in which productivity does not grow has no future. The Spanish economy grew very fast during the “marvelous decade” but with decreasing productivity. The growth was the result of more bodies working more hours with the same old tools. The figure shows that the decomposition of growth for the whole economy was a small-scale replication of the decomposition in the construction sector, which accounted for 18 per cent of GDP at the peak of the bubble and explained 20-25 per cent of the growth of the Spanish economy.
Figure: Sources of growth of market production in Spain and selected territories (1996-2005)
Note: Each coloured bar represents a different element, with bars above 0% indicating growth and bars below 0% (productivity for Spain and the construction sector in Spain) showing a reduction.
Since the beginning of the housing crisis we have seen a large drop in the number of housing starts (from 750,000 in 2006 to 30,000 in 2013) and house prices (44 per cent). In correspondence with this debacle in the housing sector, 1.5 million workers lost their jobs in the construction sector. The financial sector was also largely impacted by the burst of the bubble, since 60 per cent of the total credit of the economy was concentrated on the housing sector (loans to developers and construction companies, and mortgages to families). After 280 billion euros of provisions and 62 billion euros of new capital (41 billion of them public financial assistance) the Spanish banking sector seems to be in good condition, as reflected by the results of the latest stress test of European banks.
A quick look at previous recoveries from economic crises in the Spanish economy shows that a basic sector for the improvement of GDP and unemployment was, fittingly, the housing sector. It is somewhat naïve to think that this time it will happen again. However, in recent weeks there has been news about crowds of customers in front of property developments and queues of shoppers in the early hours of the morning. The confirmation of the first increase in housing prices since the beginning of the crisis, in the second quarter of 2014, according to INE, has also contributed to improved expectations about the possibility of a quick recovery in activity and prices.
The reality is, for the moment, quite different from that vision. You could say that while the Spanish property sector has regained a pulse, it is still at the level of a resting cyclist. In fact the price index of the Department of Public Works, based on appraisal prices, continues to fall and the index of house prices produced by the official notaries fell 5.8 per cent for the same period as the INE reports an increase. Worst of all, the latest data published by the official notaries, referring to August, show that prices further continued this fall to 8.6 per cent. On-going price adjustment is finally generating an increase in transactions, which the latest figures estimate at 14 per cent.
It is worth reviewing the conditions of supply and demand in the housing sector to assess its likely evolution. On the demand side there has been a clear change in expectations about the prospects of the sector. The purchase of real estate assets by international investment funds, which began about a year ago, has moderated pessimism and put a limit on the rate of decline in prices as sellers are more reluctant to sell for large discounts. The lowering of interest rates on deposits has produced the return of small local investors to the housing market in search of bargains on houses they could rent afterwards.
As maturing deposits at 2.5-3 per cent get renewal offers at 0.8 per cent, the return on renting, at 5-6 per cent, looks very attractive. In fact, investors in this market represent 28 per cent of buyers. Financial institutions, after an intense competition to produce SME loans, now appear to be turning their interest toward household mortgages. The data show that in July (the latest data available) home mortgages were growing at 28.8 per cent, although the base was very small. The increased funding has reduced the share of homes bought in cash by 10 percentage points, but it remains a very high proportion (around 45 per cent) fundamentally because of the participation of investors.
However, the medium and long run prospects for housing demand are poor: the Spaniards in the prime age group searching for their first home are falling at 1.5-2 per cent annually. The young people who are getting to the age of buying their first home were born in a period when Spain had one of the lowest birth rates in the world. Also current salaries at these ages are not consistent with the new solvency conditions required to get a mortgage.
On the supply side there is still a large inventory of new homes for sale. Depending on the source, this number oscillates between 600,000 and 700,000. It is true that part of this inventory is located in areas without predictable demand for many years, but there are unsold new homes almost everywhere. The reality is that even if we believe the official statistics on the stock of new housing, the current rate of reduction is extremely slow (3.3 per cent in 2013). Meanwhile the banks, despite accelerating the pace of selling the properties on their balance sheet, continue accumulating more real estate than they are able to sell. In the first six months of 2014 the portfolio of real estate assets in the balance sheet of banks has increased by 7 per cent.
We are witnessing, therefore, a stabilisation period in the Spanish housing sector, where price declines are finally generating transactions. It is likely that the market will continue to oscillate for a while between limited optimism and a lack of confidence. This is reflected, for instance, in the forecast of analysts. While the latest report from Fitch talks about single digit price increases in the coming quarters, Standard and Poor’s predicts further price falls until 2016.
Current supply and demand conditions in the Spanish housing sector tell a story of a market searching to stabilise its situation. It would be illusory to think that the real estate sector could be, this time around, the source of a strong recovery in the Spanish economy.
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Note: This article gives the views of the author, and not the position of EUROPP – European Politics and Policy, nor of the London School of Economics. Featured image: houses in Barcelona, Credit: Bjørn Giesenbauer (CC-BY-SA-3.0)
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José García Montalvo – Universitat Pompeu Fabra
José García Montalvo is Professor of Economics at Universitat Pompeu Fabra.
I am a researcher who believes that abnormal urban land rent inflation and volatility are negative for an economy in the long run, and that countries and regions that avoid this, will become manifest as outstanding economic performers in the long run. Particularly, the southern and heartland cities of the USA. Germany also succeeds in keeping urban land rent-seeking low.
The factor that most analysis is missing, is that liberal policies regarding automobile-based ex-fringe development keeps urban land rents low and stable. No other factor explains the historical behaviour of the level of urban land rent in all cities. I do not mean the perfectly normal rise in differential land rent as a city grows and as the economy grows – I mean the extractive, zero-sum rent associated with urban land scarcity. Hence the UK’s cities real price of land being hundreds of times higher than comparable non-growth-contained US cities.
An interesting obscure academic discussion and modelling exercise that in my opinion is correct on this point, is Dimitris Emmanuel (1985) “Urban Land Prices and Housing Distribution: Monopolistic Competition and the Myth of the Law of Differential Rent”. Emmanuel uses the term “monopolistically derived minimum land price”, to describe the zero-sum extractive form of economic rent in urban land.
The absurdly higher price of land also undermines productivity by a number of mechanisms.
The level of urban land rent was historically high prior to the automobile, and has reverted to historically high levels everywhere that growth management policies have been adopted, which is a kind of mania today.
We now have a considerable confusion regarding markets like Spain’s, where land rent inflation was also accompanied by oversupply of housing – hence the shallow conclusion that distortions to housing supply were not responsible for the bubble. But my contention (and others share this view) is that the housing supply curve is distorted in its shape, with short-term price elasticity being very low, but long-term price elasticity being higher with a kind of exponential relationship with prices. I argue that the cause of this, is regulatory processes yielding not to initial basic needs for more housing, but yielding in a delayed fashion to pent-up pressures incorporating speculative mania.
Carlos Garriga (2010) “The Role of Construction in the Housing Boom and Bust in Spain”, includes a lot of useful data, but makes the classic error of assuming that Spain “deregulated” land supply and it increased 30%, and therefore land supply regulations can only be responsible for 7% of the price appreciation that occurred.
Jaime Sabal (2005) “The Determinants of Housing Prices: The Case of Spain”, includes the following important observation:
“….in the particular case of Spain municipalities have a measure of
monopolistic power over the supply of land, that must be taken into
account. Many local governments own considerable tracts of land that
are released for development only when demand pressures reach the
point where they can be sold at high (“speculative”) prices, more with
a view to replenishing government coffers than for long-term planning
purposes. This speculative approach is not a negligible force behind
the supply of land in the country…….”
IMF Country Report No. 09/129: April 2009: “Spain: Selected Issues”, includes the following statements:
“The supply response was slowed by zoning regulations, reinforcing house price
increases. House price inflation in Spain deviated significantly from construction and land
costs. This is related partly to costly land use regulations. (7)
Land approved for building saw average price increases of 30 percent in 2000–01, while agricultural land increased only 5 percent. (8)
Application processes for building permits are lengthy. (9)
Furthermore, Spain’s land law entitles local governments to 5–15 percent of rezoned sites (for roads etc.). Until 2007 this provided municipalities incentives to keep prices high to benefit from sales of
excess land later on (OECD, 2007). (10) Bureaucracy, segmentation and uncertainty induced by
zoning processes aggravate scarcity of developable land further. (11) Thus, relatively tardy
supply translated the sizable demand shock into a doubling of real housing prices between
1999–2007.
Supply is also subject to long building times (Figure 3). Average time between
building permit and house completion is around 2 years. Such delays can cause large swings
in house prices, in both directions. On a structural basis, Ayuso and Restoy (2006) estimate
that 2004 prices exceeded long-run equilibrium values by 24–32 percent. However, prices
were only marginally overvalued compared to their short-term equilibrium, which takes
supply rigidities into account. At the current juncture, supply sluggishness implies peak
housing starts of 2006/07 reach completion in the recessionary period 2008/09. Thus,
inventories will keep increasing for some time. This is exerting downward pressure on prices
and transacted volumes, because price expectations are now to the downside.”
7 Brueckner (2007), Eicher (2008), Glaeser and Gyourko (2002) or Glaeser et al. (2005).
8 OECD (2005, p. 74), OECD (2007, p. 79) and Ministerio del Medio Ambiente (2008, p. 22).
9 In particular, planning of electricity and water infrastructure is complex and lengthy at 7-10 years (OECD, 2007).
10 From 2007 on legislative changes obligated municipalities to use this percentage of land exclusively for utility provision.
11 Tribunal de Defensa de la Competencia (1993, p. 149 and 1995, p. 37).
The response of supply to demand is said in some US cities, to take place as rapidly as 6 weeks. Obviously there is minimal opportunity there for a buildup of demand pressures and speculative mania for gains.
Occasional historical episodes of housing oversupply in such short-run elastic-supply markets is not accompanied by significant price inflation, and equilibrium is rapidly restored by in-migration and household formation. There is no price barrier to new entrants to the housing market that requires time to reduce, as with Spain. House price median multiples tend to not inflate much above 3 during the upside, and in the downside, have been observed to fall to a level between 2 and 3, creating maximum opportunity for REAL demand to restore equilibrium. The artificial equity created and then wiped out is minimal, even with loose credit during the upside.
Specialist writers in economic cycle theory (eg Fred Foldvary, Phillip J. Anderson) have noted that land price volatility is a major predictor of the severity of recessions. However no experts have been able to make the connection between automobile based development, and the major reduction in cyclical severity in most developed countries after 1940. The Great Depression was in fact the last of many cycle downsides where land price volatility is deeply implicated.
Ergo, the return of this volatility will make economic cycles once more just as severe as the Great Depression. This explain’s Spain’s position very well.
It is entirely wrong to seek a “restoration” of the urban land price levels to that of the bubble. The crash WAS the price restoration that should be sought to be embedded by policy makers. The LSE Spatial Economics Research Centre is among those doing valuable work on the long term negative consequences for a national economy with inflated urban land rent. I hold that it reduces the real production that is at the heart of the conflict between Say’s Law and Keynesian “aggregate demand”. There are a number of exactions against total production, on the part of non-producers; hence the assertion that production=demand, fails. It is not just that rentiers gain an unearned share of production, production is also lower than otherwise.
Differential rent, due to location efficiencies and agglomeration effects and productivity and spatial growth and income growth, is an exaction on GROWTH, not an exaction on the status quo, so that it does not have a destructive effect on production. It is endogenous to production, whereas extractive rent is not.