Take the banks' umbrella away

One might answer that competition between lenders protects borrowers against exploitation. That's true if exit fees are banned, so that borrowers can change lenders without incurring fees that wipe out the interest savings. But why create the problem in the first place? Why not require the interest rate to be specified up-front?

One might answer that a fixed interest rate would tend to be higher on average, because the lender would need a buffer against variations in its own borrowing costs. That's true. But property prices would fall to compensate for the fall in borrowing capacity. Hence fixed interest rates, like any other measure tending to reduce property prices, would be helpful if introduced sufficiently early in a rising market: it would lean against the formation of a bubble.

One might answer that fixed-interest-rate loans would reduce the influence of official interest rates on inflation. But there are better ways to control inflation. For example, an increase in the rate of compulsory saving would exert downward pressure on inflation without the nasty redistributive effects of a rise in interest rates.

If it's real-estate inflation that we're concerned about, we need to understand that property bubbles inflate when people pay more attention to the direction of prices ("capital gains") than to the prices themselves (and whether they are commensurate with earnings). Hence the remedy is to reduce the attractiveness of "capital gains" relative to current income -- by reducing (preferably to zero) taxes on current income, including income from assets, and increasing the public capture of land values and/or uplifts in land values.

Such reforms, which may be described as "land-value capture", make housing more affordable for both renters and buyers, because the greater need to generate income from property strengthens the bargaining position of those who can supply that income (tenants) or relieve the need for it (buyers) against those who have that need (current owners). Affordability is the balance of your amenity and your spending power against the price or rent that you have to pay. Policies that strengthen your bargaining position tip that balance in your favour.

One form of land-value capture is a holding charge proportional to the value of the land. This has the added advantage of exerting negative feedback on prices, stabilizing prices around the long-term trend: when prices rise, holding costs rise, encouraging sales and discouraging purchases, thus limiting the rise; and the opposite when prices fall.

Another form, of course, is a "capital gains" tax. This lacks the negative-feedback feature. But if it replaces an equal amount of taxation of current income or expenditure, it can arrest a price crash that is already in progress: the reduction in current taxation increases the immediate capacity of current and prospective debtors to service loans, and that immediate capacity is not diminished by the prospect of paying a higher capital gains tax at some future date.

I say this because, as is clear from recent posts at the LVRG Blog, I believe that a price crash is indeed in progress.

Why do prices peak and fall? If we make reasonable long-term assumptions concerning the interest rate, the appreciation rate, the property tax rate, and the factor by which the income tax system magnifies capital gains relative to current income, and then try to calculate the price/rent ratio that makes buying a property competitive with renting in the long term, we reach the embarrassing conclusion that prices should be infinite. So what keeps them finite? Obviously the constraints of the financial system. (Unfortunately this "obvious" conclusion and its "embarrassing" foundations are not found in my writings prior to November 2009.)

That is why, as I say above, "property prices are determined by borrowing capacity". Bubbles burst, not because prices overshoot some rational calculation of what the properties are worth, but because prices overshoot what people can reasonably afford to borrow.

But if we repeat the price/rent calculation assuming the kinds of tax reforms proposed above, we get answers that are known to be financially sustainable. Thus the ultimate significance of those tax reforms is not that they discourage the seeking of "capital gains" in excess of rational prices (although that helps), or that they apply negative feedback to stabilize prices at rational levels (although that also helps), but that they bring those "rational" prices within reach of the financial system.

Without tax reform, buying a home cannot remain affordable, because as property prices seek their "rational" level, they will rise above the saving and borrowing capacity of prospective buyers. By themselves, financial regulations that limit the borrowing opportunities of prospective buyers have little effect on affordability, because changes in borrowing power tend to be absorbed by changes in market prices.

Without tax reform, there can be no financial stability, because as property prices seek their "rational" level, they will break the financial system. By themselves, financial regulations that transfer risks from borrowers to lenders will not stabilize the financial system, but will only change the manner in which it falls over: instead of buyers losing faith in the greater fool, we'll get lenders losing faith in the greater fool.

Moreover, without tax reform, financial regulations that make lenders more cautious are not politically sustainable, because they are too easily blamed for locking prospective buyers out of the market, and because they can be repealed without any immediate fiscal impact. In contract, tax reforms by themselves can keep property prices within reach of a deregulated financial system, and cannot be undone without imposing new taxes, raising old ones, or cutting expenditure.

So, having condemned certain practices by which lenders oppress borrowers and tenants "after the fact", and having rejected the lenders' excuses, I must concede that such practices are not the cause of unaffordable housing and financial instability. The cause is a tax system that makes asset appreciation more attractive than current income.