Monthly Archives: October 2014

Why rising home prices won’t devour the economy

Have you ever tried to rent an apartment in Brooklyn and come to the conclusion that rising home prices are ruining the world? Well, it turns out that may actually be true – at least according to Quartz’s Tim Fernholz.

In a recent article, Fernholz argued that the rising cost of real estate will eat up an ever larger share of the world economy, with potentially devastating consequences. Fernholz essentially lays out MIT economist Matt Rognlie’s critique of Thomas Piketty’s recent blockbuster book “Capital in the 21st Century”.

In his book, Piketty claimed to show that global capital has been accumulating in the hands of a small number of rich people since the 1950s and will continue to do so until inequality reaches dangerous proportions. This trend is inherent to capitalism, Piketty argued, and can only be stopped through government intervention.

Rognlie doesn’t dispute Piketty’s data, but claims the Frenchman misunderstood it. He points out that 80 percent of the wealth accumulation in Piketty’s data is due to real estate. If you take housing out of the equation, the growth in private wealth is quite small, putting Piketty’s argument in doubt (see graph).

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Whether we should believe Rognlie or Piketty essentially boils down to two questions: is capital easily substitutable for labor, and are different forms of capital easily substitutable for each other? Piketty answers both with yes.

Private wealth (or capital) can only eat up a growing share of the economy and heighten inequality if income from labor declines in relative importance. In (very) simplified terms: Apple can only dish out huge dividends to its stockholders if it doesn’t have to spend all its earnings to hire people. So far, technological advances have generally made labor less important and more replaceable. Rognlie believes this trend can only go so far, as capital depreciates over time and labor will always be needed to replace it. Piketty believes the trend can go a lot further. So far, the verdict is out.

The second question is more important in this context. Piketty doesn’t really care that much what the wealthy invest their money in. It could be gold, stocks, oil, real estate – the point is simply that their wealth is growing and that different forms of capital are in theory replaceable. Fernholz (i.e. Rognlie), on the other hand, claims that the accumulation of wealth is only due to a growth in the value of real estate and that other forms of capital could not record a similar growth.

Real estate prices have been growing because population growth and urbanization make land in cities scarcer. The growing inequality noticed by Piketty is thus really a growing gap between income from real estate and income from everything else, Fernholz claims. According to this reading, the rich are getting richer not because of any trend inherent to capitalism, but simply because they happen to own real estate. And as population growth and urbanization are expected to continue, growing home prices will consume an ever larger share of the world economy. This trend will suck capital from other, more productive industries and dampen growth.

The argument is compelling and relatable. It is also highly questionable – mainly because British economist David Ricardo made a very similar claim more than 200 years ago and turned out to be wrong.

Ricardo argued that explosive population growth in the early 19th century would make agricultural land increasingly scarce and valuable. After all, it had to feed a growing population. This, Ricardo argued, meant landowners could command ever higher rents for land to the point that rents would eventually make up an overwhelming portion of national income and stifle growth in other industries.

In hindsight, Ricardo underestimated the effect of technology. As new techniques and pesticides made agriculture more productive and trade globalized, farming land actually lost value compared to other assets.

Private wealth still accumulated in the hands of very few during the 19th century, as Piketty showed, but its composition shifted from rural land to urban real estate and industrial capital. In other words: different forms of capital proved more easily substitutable for each other than Ricardo thought and the rural landowners of the 18th century became the industrial tycoons of the 20th. Either way, private wealth grew tremendously as a share of the overall economy.

It is possible that Rognlie is repeating Ricardo’s mistake to underestimate the effect technology can have on land prices. Population growth and urbanization have driven up urban and suburban real estate prices, but will that trend necessarily continue? New construction techniques and the trend to build higher and denser are already lowering housing costs, as is improved transportation.

Office workers in Manhattan may have to pay a fortune for scarce apartments on the Upper West Side or Brooklyn today, but what if magnetic trains shorten the commute to the countryside to minutes within decades? As workers can move further and further away from their employment, land in urban centers will lose in value. Denser building has the same effect.

History suggests that growth in the value of a certain asset class is never as inevitable as it seems at the time. Ricardo was certain agricultural land would dominate global wealth, but the opposite occurred. 200 years later, Rognlie thinks the same of urban land, and he could end up being just as wrong and real estate’s share of total wealth could start falling.

If Piketty is right, global wealth will then simply shift to a new, growing asset class – as it did in 19th century Britain. The result would be the same: the rich become richer.

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