The man from Deutsche Bank gets it wrong, and right.

In an Australian publication, Sahil Mahtani of the Deutsche Bank sounds a warning note about London's property market.

Every £1 invested in London property in 1990 is now worth £5, double the performance of the FTSE 100.

Conservative estimates put average London house prices at 13 times average gross incomes.

London residential mortgage debt amounts to a quarter of the country’s total.

London’s housing market is huge, expensive, and hot. It’s not hard to find stories of property insanity in the capital and popular opinion holds that its a flood of foreign investors buying up homes and leaving them empty to accumulate value that has sparked the boom.

Mahtani says it’s simple supply and demand — the supply of homes has failed to keep pace with demand from buyers, be they foreign or otherwise.

But crucially Mahtani sees a second, overlooked factor for spiraling prices — buyers believe house prices will keep going up. People are willing to pay silly prices on the expectation prices will keep rising and they can cash in themselves later. That in turn bids up prices.

On the first point, he almost immediately contradicts himself:

He points to the Hong Kong property crash of 1997, when prices dropped 40% in just over a year, as evidence for what happens when the wind changes direction on public opinion.

Here’s Mahtani:

A shift in expectations about future supply was much more instrumental in bringing about the downturn. The post-handover government had made it known that it would welcome a decline in property prices and would increase supply by 85,000 units a year. In retrospect, at no point during the next five years did housing completions reach 35,000 annually. Yet because the decision had credibility, it changed expectations and the 85,000 figure is still cited today as a reason for the market decline. The government announcement precipitated a change in psychology that diminished the speculative increment in the market.

It didn’t matter that supply increased nowhere near as much as promised — the “psychology” had changed and that was enough to send buyers running.

In other words, the supply of housing did not change, but public perceptions did, which tends to suggest that the fall was all to do with psychology and nothing to do with supply and demand. Ricardo, in his Law of Rent, recognised that land prices are driven by public sentiment and there is ample historical evidence that this is so.

Whilst there is also evidence that supply and demand affect land prices locally, within London the "bubble" effect is so strong and demand is so ramped up by it, that there is simply not the physical space to increase supply enough to have any effect on price.

Those with large landholdings around the capital, hungry for for the windfall gains that change of use permission would bring, would like us to believe that the only way of controlling the price of land is to by controlling the supply. As Mr Mahtani points out, it is much more effective to control the demand.

The supply and demand curve for "money" (2)

Continuing my post of last week, where I looked at the supply and demand curve down to about the interest rate which people are or would be prepared to borrow to spend on bricks and mortar, which is about 8%.


If we just look at this supply and demand curve, we observe that the net return to savers is pretty flat whoever the borrower is.

But there is something else dictating interest rates. There is a subtle difference between 'saving' and 'investing'. Basically, households 'save' and businesses 'invest'. (It is quite possible that household savings go into business investment, which is double plus good, but that is a overlap and not the main event).

The distinction is this: let's say a farmer normally harvest 52 units (weeks' worth) of food, exactly enough to see himself through the whole year. In a hypothetical good year he harvests an extra 20 units.

i. He can 'save' those 20 extra units by selling it to hungry people on credit, so when the harvest is not so good, he can call in the loan of food. He can also demand the payment of interest on that loan (he gets back more food than he lent out), so in future, he could, if he wished, consume an extra 2 or 3 units a year for the rest of his life, but that is only at the expense of the original borrowers, who have to make do with consuming 2 or 3 units less than otherwise.

ii. Or he can 'invest' that food by exchanging it for better implements, or by exchanging it with somebody who will improve his walls and drainage. In future, the farmer can now produce 2 or 3 extra units of food each year, but without anybody else having to consume less.

That is what drives the minimum interest rate which 'savers' will accept. If the farmer knew he could increase his future potential harvest by an extra 4 units a year by 'investing' 20 units this year, then a buyer on credit would have to offer to pay at least 4 units a year in interest before the farmer will consider 'saving' rather than 'investing', and so on.

(The problem is that savers cannot just invest in productive assets, because those are all monopolised by limited companies, so before savers can get a share of the profit from the underlying productive investment, they have to pay a ransom payment to an existing shareholder, which pushes up returns to existing shareholders at the expense of future shareholders and the economy in general, separate topic).

As we observed last week, the interest rate which people are willing to pay depends largely on how much they need to borrow, how quickly they need to spend the money, and how soon they hope to pay it back.

That all makes sense so far and the arrangement is to our overall benefit. Where it goes crazy is once interest rates drop below that rate of approx. 8%:

Broadly speaking, the descent into insanity goes in the following three stages, but the general rule is still that the further into the future the borrower's hoped for extra consumption will be, the lower the interest rate he is willing to pay:

1. If you can borrow money for less than 8%, then the lower interest rate just goes into higher land prices (rather than bricks and mortar), i.e. if you can rent a house for £6,400 (net of landlord's costs) and borrow at less than 8% to buy the building, you are happy to do so. But if you can borrow at (say) 5%, it is worthwhile paying/borrowing £128,000 (it still only costs you £6,400 a year), and that extra £48,000 just goes into the land monopoly black hole.

2. If people expect nominal land prices to continue to rise at a long term rate of 5% or more a year, then if you can borrow at less than 5%, it makes sense (on an individual level) to buy land for the sake of it (money into the LMBH), whether you need it or not, because you can realise a gain (more money into the LMBH) in future which will pay off the interest for you.

3. Because bankers seem to get paid according to the volume of loans they can make, rather than the bank's actual profit margin, bankers try to "grab market share" by lending out at very low rates (Bradford & Bingley, Northern Rock etc), the bank itself (the bankers' employers) make losses on such loans of course. It is no coincidence that the cumulative losses of all UK banks over the credit bubble decade were approx. equal to the total bankers' bonuses paid in those years.

None of these three stages are of any remote benefit to society in general or the productive economy as a whole, and are in fact incredibly damaging. They do not help people spread consumption over their lifetimes by borrowing/saving; they do not lead to any investment in productive capacity.

Bricks and mortar are of course productive capital if they are in the right place, but the land is not, and even it were, pushing up the price does not increase the amount available - and a society which believes that house price rises are A Good Thing tends to be a NIMBY society, so we end up with less productive capital (housing, factories and so on).

Why UK and other governments think it is a good idea to constantly nudge the economy towards these final three stages, and why so many people go along with this nonsense is a mystery to me.