May 20, 2008 | posted by Michael Baxter in Cost of food, Oil | comments (1) |

Yesterday we got our fingers rapped.

It is a commonly held view that demand for food, energy and houses does not change with price.  Or, as an economist would say, “Price elasticity of demand for food and energy is inelastic.”

But we said that,  “In the longer-run, demand for food and oil, and houses, is elastic after all. And for food and oil, so is supply.” 

But a reader took exception:

“I don’t know about the author but my long-term plans always include somewhere to live and something to eat! – one of the first things that you are taught in economics is supply and demand and price elasticity – most professors use the example of food as an inelastic commodity. I would be interested to know on what basis the supply of this and of houses are seen by the author as ‘elastic’.”

This is an important point, because the idea that in the long-term demand does fluctuate with price for these items  is crucial to our belief that the price of food and oil will fall eventually, and in the process create the seeds for the next economic boom.

First, take the example of food.    The reaction to high food prices in the West will come in three stages.
Stage 1: More and more of us will stop buying those expensive pre-packed meals. 

Stage 2:  We will waste less, and start looking at ways of making better use of natural ingredients.    This change is already manifesting itself in two ways.  Firstly, there has been growing media interest in old-fashioned type cooking methods – you know, when we try and get the food to stretch further. 

Secondly, we have recently noticed attention being focused on waste.  Suddenly, media reports have focused, for example, on the positive benefits of plastic, namely that it reduces waste.

Stage 3: That bit of land at the bottom of the garden is used as a vegetable patch, and the food grown becomes available to eat.

Not everyone will follow all of these three stages, but that is not the point.  If some people do, the results will be less demand for food in the shops.

A similar argument used to apply to oil.  Back in the mid 1970s, as price went up demand stayed the same; we were told that demand for oil was price inelastic.   Then we saw the US speed limit reduced, and a move towards more-fuel-efficient cars.

It is happening again.  Perhaps the single biggest reason why Toyota is doing so well at the expense of GM, Ford and Chrysler is that it correctly foresaw the demand for greater fuel efficiency.

As for house prices, here there are two reasons.

Firstly, no matter how much we need somewhere to live we can not pay more than we can afford.    If price rises too high, we will opt to live in a smaller home, or younger people will live with their parents for longer.

Secondly, as Capital Economics recently showed, and as told here on April 24, many homes in the UK are under-occupied.  Apparently, according to the Survey of English Housing, no less than 47 per cent of existing owner-occupier dwellings – that’s 6.8 million homes – are under-occupied.  Tellingly, however, only 18 per cent of private rented properties are under-occupied.

This would suggest there is plenty of slack in the system, and when price reaches a level that is unaffordable, people will just reconsider their living arrangements.

That is why we think house prices will fall, and probably overshoot on the way down.    Oil has already risen too high, although speculation may force it to go even higher, but it will fall eventually, probably to at least half its current level. It may even fall too far, and for a while be too cheap, given economic fundamentals.  The same may well apply to food.

May 19, 2008 | posted by Michael Baxter in Cost of food, Oil | comments (3) |

It’s a new paradigm now – “this time it’s different.”    That’s the cry you will hear.  Well, be warned, it rarely is.

And this is both good news and, depending on your point of view, bad news.

It’s good news because the price of oil and then, in time, food, will eventually fall in price, and economic recovery will be back on.  It’s bad news, depending on your point of view, because house prices will fall too.  It is just that some will be celebrating over that.

Price is down to demand and supply.    But sometimes demand gets distorted by our own exuberance.

There was a time when house buying was a smart financial move.    Back in the 1970s, the real rate of interest, that’s interest rate minus inflation, was actually negative.  So it made sense to borrow.

Back then it made sense to get as big a mortgage as you possibly could, because chances were your salary would go up every year, but your mortgage would stay the same. With that in mind, consider this: in 1975, inflation was 24.5 per cent. 

The trouble is, that principle no longer applies.  Thanks to the modest wage inflation we experience today, our mortgages don’t get cheaper liked they used to.

But instead of fretting over long-term affordability, we got caught up in the wonder of ever-rising house prices. 

Buy-to-let investors added to the mad dash, while others saw their home as their pension. 

It was great wasn’t it?  It was what economist Roger Bootle calls “money for nothing.”

We had become leveraged investors. But this is a dangerous thing to be.  Leveraged investing became popular in 1929 too, but when the stock market burst that year, the pain was made much, much worse because investors who thought they had borrowed their way to stock market riches, found that actually they had borrowed their way to illusion built upon mirrors that were just as capable of magnifying losses as they were profits.

But don’t worry, this time it is different.  Sure, house prices to income are at an all-time high, but that’s not what matters.  It’s affordability that counts. 

There were two snags with that argument.   

First of all affordability changes.    Interest rates change.  If house prices are at an all-time high relative to earnings, and then all of a sudden inflation soars and rates shoot up, then the housing market becomes dangerously exposed.

The idea that low inflation was here for good was always suspect. And Investment and Business News first warned of this danger four years ago.

Secondly, it is debatable that affordability has improved anyway. The low inflation of recent years might make borrowing cheaper at the outset, but over 25 years it could become more expensive.  As a result, it seemed as if the UK housing market was a ticking bomb – just waiting for the first crisis to set it off.    We have been warning of this danger for four years too.

So, okay, houses might not be more affordable in the long-term, over a 25 year mortgage, for example, but at least they are cheaper in the short-term, say the bulls, and after all, as Keynes once said, “in the long-run we are dead.” 

But, even the argument houses are more affordable in the short-term is open to debate.  Most statistics comparing affordability today with the past look only at the rate of interest.  They do not take into account the cost of actually repaying the amount borrowed.

In 2007, one report warned that the lack of housing supply could lead to average house prices hitting 10 times average income.  But think about that.  Assume for the sake of simplicity that tax takes up 50 per cent of average income.  If a house is priced at 10 times average income, in order to repay a 100 per cent mortgage, the borrower would have to forego 50 per cent of net income every year for 20 years.   (And that is with a zero interest rate.)

When you take into account the cost of repaying a mortgage, the idea that house prices could possibly continue rising in a sustainable way was always ludicrous.

Also, up until a few years ago, tax relief was available on mortgages.  Remember MIRAS?    This is no longer available.  Take into account MIRAS, and it seems likely that by 2007 affordability was almost as badly stretched as the early 1990s – and that is without taking into account the longer term risks and costs mentioned above. 

House prices were too high; people were buying, others were investing for no better reason than that prices had risen the week, before, therefore it was assumed they would rise next week. 

The housing market had disaster written all over it for some time, and when the dust settles the regulator needs to look long and hard at all those reports, some published by respectable bodies, talking up house prices.  The media too, especially the BBC and Channel 4, should come under the spotlight.  

But the good news, just as the housing market is not immune to the fact that markets always correct, neither are the markets for oil and food.

Sure, oil has risen to levels that a year ago were considered unthinkable, and the media talk about the end of cheap food.  Sure, in part prices are rising because demand is rising. 

China and India want more oil.  Their consumers want more meat.

Meat is not efficient – livestock needs to be fed. It would be much easier if the land used to grow food for livestock, was used to grow food for us instead.  How selfish of the Chinese and Indians to want a Western type of diet.

But, right now, price is too high.  Plain and simple. 

This was always going to mean one of two things.  Firstly, producers invest more in finding alternative technology, renewable energy, for example. At the same time,    more land will be allocated for food, farmers will invest more in technology, productivity will rise.

In China, the pig population, decimated by blue ear disease, but in any case on the wane as pig rearing was given less priority, will grow.

And just as output rises, demand will fall, because that’s what happens when economies slow down. With that, the price of oil and commodities will drop.

Economists talk about price elasticity of demand and price elasticity of supply.      If  demand or supply are inelastic, they do not alter that much with price.  Price goes up, demand and supply barely change. 

But in the longer run, demand for food and oil, and houses, is elastic after all.   And for food and oil, so is supply. 

That is why bubbles always burst.

It is just the way it is.