Housing Shortages and the Elasticity of Demand

Almost no one lives in the house of their dreams. We rent the flat we can afford, not the one we'd choose. We buy further out than we wanted, or smaller than we planned, or later than we meant to. The spare room becomes a bedroom. The study becomes a nursery and the nursery stays a nursery. The adult child who would have moved out is still down the hall. We tell ourselves the commute is fine. We build a granny flat to accommodate ageing parents. Whether we rent or buy, almost all of us are living in a compromise, and we made it because of what housing costs - be it the purchase price, the mortgage repayment cost, planned renovation costs, maintenance costs or rental costs.

That ordinary, universal experience is the reason a claim now circulating cannot bear the weight being put on it. The claim, in its various forms, is that we are building enough houses, or that at some lower rate of population growth the current rate of construction would be sufficient. The evidence offered is usually a ratio: dwellings against households, or population growth against completions, or population per dwelling with the conclusion that if the two roughly match, or match some historical figure, then demand has been met and there is no real housing shortage.

I am not going to argue the opposite. I am not going to tell you there is a shortage of a particular size, because I do not think anyone can honestly tell you that. I am going to argue something narrower, and I think harder to dismiss. You cannot cleanly conclude adequacy from a ratio like that, in either direction, because the quantities in it are not independent of the thing you are trying to judge. And what we most need to know, how much housing demand has been compromised away, and at what price it would reappear, is not in the data at all.

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The Federal Budget in Pictures

The Federal Budget papers contain a number of charts, tables and forecasts. The forecasts are the part most people focus on. They are also the part most likely to be misunderstood.

When the Reserve Bank publishes a forecast, it is trying to predict the path the economy will take. The Bank looks at the data, consults its models, applies its judgement, and prints a number it thinks is most likely to happen. When the budget papers publish a forecast, they are doing something very different. They start with where the economy is today and assume it returns to something like normal over the medium term. The forecast then asks a simple costing question. Under normal economic conditions in the out years, what would revenue and expenses look like?

The distinction matters. The budget forecasts are not predictions. They are an arithmetic exercise built on top of an assumed normal economic equilibrium. The numbers that define that equilibrium, things like the medium-term GDP growth rate, the wage and price assumptions, the unemployment anchor, are framework conventions. They are not Treasury's literal central case for the path the economy will take. But, if the equilibrium is wrong, every number that flows from it is wrong too.

This year's papers contain an equilibrium that does not add up.

The reversion always looks the same

Start with real GDP. The black line is what actually happened. The orange lines are successive Treasury forecasts. Almost every forecast bends back toward 2.5 to 3.5 per cent growth, regardless of where the economy actually is. That end point was higher in the 2010s and it is lower now. 

A budget about today, dressed in the language of tomorrow

Treasurer Jim Chalmers has now handed down five budgets. All of them, including this one, project deficits. The forward estimates show deficits stretching to 2029-30 and beyond. The budget itself does not return to balance until 2034-35, on Treasury's own modelling. Gross debt crosses \$1 trillion next year and reaches \$1.25 trillion within four years. Interest on that debt is now the second fastest growing expense in the budget, behind only the National Disability Insurance Scheme. At \$30 billion a year, interest alone exceeds the total cost of the Pharmaceutical Benefits Scheme.

The Treasurer calls this "responsible fiscal management." The budget is built around a claim of intergenerational fairness. Both descriptions sit awkwardly with the arithmetic, but the deeper problem is simpler. This is a budget about managing the present. It does very little to set the country up for the future: the productivity slump goes largely unaddressed, fiscal resilience continues to erode, and the housing supply problem is treated as a tax problem rather than a supply problem.

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Finding r-star after the Great Divergence

TL;DR: r-star, the real neutral rate of interest, is one of the unobservable star variables in mainstream macroeconomics. It is notoriously hard to estimate. The Australian IS curve coefficient on the real-rate gap is small relative to macro noise, so the model cannot choose between a growth anchor, a bond-yield anchor, or a blend of the two. Those three approaches, drawing on Wicksell, imply a real r-star between roughly 1.5 and 2.6 per cent, and a nominal neutral cash rate between about 4.0 and 5.1 per cent. With the RBA policy cash rate at 4.35 per cent, policy is not extreme. The data alone does not say whether it is mildly restrictive or mildly accommodative. The post-GFC track record and Governor Bullock’s recent language both lean toward the yield-anchored interpretation, on which 4.35 per cent is mildly restrictive.

Finding r-star after the Great Divergence

After doing additional analytical work that further shaped my views, I have withdrawn my original post. 

Please see the replacement post here.