Tuesday, December 23, 2008

Falling Prices (5) - Houses Too

Inflation makes investment easy, people can buy assets, do nothing, and watch them slowly increase in price. The benefit comes at the expense of people on fixed incomes, as inflation robs them of their wealth. Of course, inflation does not affect all assets evenly. Some assets increase price more quickly than others, and housing has done better than most other asset types. People have brought dwellings and watched their wealth increase, as inflation pushed up the value of their homes.

Our long experience of house rising in price is actually an illusion. The reality is that houses age and suffer from wear and tear over time. Therefore to be a good indication for economic decision making, the price of dwellings should decline slowly to reflect that reality. In ten years time, my house will be ten years older, so its price should be less than it is now. If inflation were eliminated, residential dwellings would gradually decline slowly in price year by year, reflecting the fact that they are getting older and less modern. A thirty year old house would be worth less than a two year old house.

Unfortunately, people have become so used to inflation that the thought of their home not increasing in value over time is quite disturbing. The reality is that most capital goods decline in price over time. Manufacturing plant and equipment can be almost worthless when it has reached the end of its useful life. Nevertheless, business people are happy to buy plant and equipment knowing that its resale value will decline over time, because they can use it to produce goods that can be sold for a return that will compensate them for the depreciation in value of their assets.

In the same way, we have no problem with buying a car that will be worth less next year than it is this year, because the transport services that the car provides are worth more to us than the decline in price and the cost of maintenance.

The reason that we would be disturbed by a decline in the price of houses is that we tend to think of a home purchase as an investment. This is incorrect thinking. In the absence of inflation, the purchase of a home is consumption expenditure. The person buying a home consumes all the shelter services that it provides. The purchase price is actually an up-front payment for a very long-term stream of services. (Some of the shelter services that are not used up may be sold when the owner is ready to move on)

The only way to turn the purchase of a dwelling into an investment that produces a return is to rent it out to some willing to pay for the shelter services. In addition to providing a steam of income, the rent would compensate for any decline in price.

If there were no inflation, people would have to stop seeing their home as an asset that will increase in value over time. People would only buy a house to live in, if they valued the shelter services it could provide more than the decline in price and the cost of any maintenance.

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