Das House Kapital: The evolution of housing wealth

Volker Grossmann, Thomas Steger

The ratio of wealth to income has increased substantially since WWII. Despite the key role of housing wealth in this process, an appropriate macroeconomic model that can explain recent history and assess the future is still lacking. This column presents a novel macroeconomic model designed to investigate the evolution of housing wealth in a growing economy with a fixed overall land supply. A key implication is that rising house and land prices are natural phenomena in a growing economy. Further, rising wealth-to-income ratios appear to be an important trigger for the long-term growth of the finance industry.

The ratio of private wealth to income has increased in major industrialised countries since WWII (Piketty and Zucman 2014a, 2015). The recent debate has stressed that housing wealth increased considerably more than non-residential wealth (Bonnet et al. 2014). This observation is consistent with rising real house prices since WWII, as documented by Knoll et al. (2014). They show that the increase in house prices goes hand in hand with rising land prices and argue that the price channel of rising land valuations has played a major role in the observed surge in wealth-to-income ratios.

Why should we care about the evolution of the wealth-to-income ratio? There are two major reasons:

First, a long-term increase in the wealth-to-income ratio may change the functional income distribution to the advantage of capital income recipients (Piketty 2014). The housing sector seems especially important in this context, as argued by Rognlie (2015), who demonstrates that the increase in the economy-wide capital income share is driven exclusively by the housing sector.

Second, Gennaioli et al. (2014) argue that the long-term surge in the financial sector is driven by a rising wealth-to-income ratio, since one key function of finance is to preserve the stock of wealth. The housing sector once more seems crucial, as shown by Jordá et al (2016), who document a rising share of real estate lending in total bank credit.

The House Capital Model

In a recent paper, we provide a novel, two-sectoral macroeconomic model that is designed specifically to investigate the evolution of housing wealth (Grossmann and Steger 2016). To capture the importance of land for housing production in a growing economy, the model builds on three premises:

The overall land endowment is fixed;

Production of new houses requires land as an essential input, whereas replacement investment does not; and,

Land employed for real estate development must be withdrawn permanently from alternative uses.

We argue that Premise 1, ‘Fixed Land Endowment’, represents a general law of nature. A sceptic may respond that land-augmenting technical change, land reclamation, and land development due to infrastructure investment can raise the available quantity of land. This is indeed plausible in the short to medium run. In the long run, however, the total amount of economically usable land is certainly fixed by nature. Increasing land scarcity, already in recent history, is also compatible with rising farmland and urban residential land prices, as documented by Knoll et al. (2014) for 14 advanced countries since WWII.1

The assumption that replacement investment does not require land (Premise 2) is not only plausible; it is also indispensable, particularly with regard to Premise 1. For this specific reason, the housing sector is modelled more elaborately, compared to the standard macro-housing model, in that there are three types of firms:

Real estate development firms which transform (undeveloped) land into residential land;

Construction firms which manufacture residential buildings; and,

Housing services firms which produce housing services.

The analysis distinguishes, for the first time, between the extensive margin of the housing stock (setting up new housing projects through real estate development) and the intensive margin of the housing stock (enlarging existing houses through construction).

The calibrated model is employed to simulate the consequences of economic growth for private wealth-to-income ratios (housing wealth and non-residential wealth) driven by exogenous population growth, exogenous technical progress, and endogenous capital accumulation. The simulation gives us country-specific time paths for housing wealth and non-residential wealth (relative to income) from 1955 until 2100. This experiment is conducted separately for France, Germany, UK and the US. The results for the housing wealth-to-income ratio are shown in Figure 1.

Figure 1. Housing wealth-to-income ratio from 1955 until 2100

Notes: Housing wealth (PHN): gross housing assets – i.e. not reduced by mortgages and other financial liabilities of private households. Income: net domestic product (NDP). Data source (empirical data): Piketty and Zucman (2014b).

The dotted (red) lines show the empirical data, whereas the solid (blue) lines display the model-based time paths. The calibrated model replicates the post-WWII increase in the housing wealth-to-income ratio between 1955 and 2010, on average, remarkably well. It also suggests a considerable further increase of the housing wealth-to-income ratio in the future. Assuming a (future) capital income tax rate of 20% and a subjective discount rate of 2.5%, the implied long-run housing wealth-to-income ratio (black, dashed line) is about 410%. The long-run non-residential wealth-to-income ratio (not shown), which comprises the value of physical capital and of non-residential land, amounts to 320%. The implied overall wealth-to-income ratio of about 730% slightly exceeds the range of values suggested recently. For instance, assuming a net savings rate, s, of about 10% and a real GDP per capita growth rate, g, of about 1.5%, Piketty (2014) argues that the (private) wealth-to-income ratio, s/g, would rise to 600-700% in the long run.

Land prices and house prices

What is the basic mechanism that increases the wealth-to-income ratio? Given that the overall land endowment is fixed (Premise 1) and that land represents a rivalrous factor (Premise 3), land becomes scarcer and more expensive as the economy grows. Consequently, land prices and – given that the land share in housing production is substantial – house prices increase. The price channel of increased land valuations plays a critical role in the process of pushing the wealth-to-income ratio up for two reasons:

Rising house prices trigger an increase in the ratio of housing wealth to income.

The non-residential wealth-to-income ratio rises in the process of economic growth, which reflects capital accumulation and the increased value of non-residential land due to rising land prices.2

Figure 2. Land prices and house prices (‘average economy’): calibrated model (left panel) and empirical data (right panel)

Notes: Source (empirical data): Knoll et al (2014).

Figure 2 (left panel) displays the evolution of land prices and house prices, as implied by the calibrated model, assuming that the labour force grows by an overall factor of 1.75 and that total factor productivity rises by an overall factor of 3.5 between 1955 and 2100. The model yields an increase in the (aggregate) land price, between 1955 and 2010, by a factor of about 6.2, whereas the data (right panel of Figure 2) show a somewhat higher increase by a factor of 7.8. As regards the (aggregate) house price, the model produces an increase between 1955 and 2010 by an overall factor of about 4.2, compared to a somewhat lower empirical growth factor of 3.3. Therefore, the model captures an additional and important stylised fact, namely that land prices increase by more than house prices.

Major insights

The House Capital Model enables us to think about land prices, house prices, and wealth-to-income ratios in a growing economy when the overall land supply is fixed. The major implications are as follows:

Rising land prices and house prices represent natural phenomena in a growing economy. This implies, for instance, that monetary authorities need not be concerned about increasing real house prices, provided that there are no indications of house price bubbles. The interaction between scarce land and housing production materialises in a modern version of Ricardo's (1817) principle of scarcity.3 Societies today are confronted with residential investments to meet the increasing demand for housing services subject to scarce land. Economic growth hurts those groups which own little (housing) wealth, because they face higher rents and are not compensated by growing (housing) wealth. Increasing land scarcity in a growing economy, which shows up in rising wealth-to-income ratios, appears to be an important fundamental trigger for the long-term growth of the finance industry (relative to GDP), as documented recently by Philippon (2015) and Jordá et al. (2016).

References

Bonnet, O, P-H Bono, G Chapelle and É Wasmer (2014) “Does housing capital contribute to inequality? A comment on Thomas Piketty's Capital in the 21st Century", Sciences Po Economics Discussion Paper 2014-07.

Gennaioli, N, A Shleifer and R Vishny (2014) "Finance and the preservation of wealth", Quarterly Journal of Economics, 129 (3): 1221-1254.

Glaeser, E L, J Gyourko and R E Saks (2005) “Why have house prices gone up?”, American Economic Review Papers and Proceedings, 95: 329-333.

Grossmann, V and T Steger (2016) “Das House-Kapital: A theory of wealth-to-income ratios”, CESifo Working Paper, No 5844.

Jordà, Ò, M Schularick and A M Taylor (2016) “The Great Mortgaging: Housing finance, crises, and business cycles”, Economic Policy: 107-152.

Knoll, K, M Schularick and T Steger (2014) “No price like home: Global house prices, 1870—2012”, CEPR Discussion Paper DP10166, September.

Philippon, T (2015) “Has the US finance industry become less efficient? On the theory and measurement of financial intermediation", American Economic Review, 105(4): 1408-38.

Piketty, T (2014) Capital in the 21st century, Harvard University Press, Cambridge.

Piketty, T and G Zucman (2014a) “Capital is back: Wealth-income ratios in rich countries 1700–2010”, Quarterly Journal of Economics, 129: 1255-1310.

Piketty, T and G Zucman (2014b) Online data set for "Capital is back: Wealth-income ratios in rich countries 1700–2010".

Piketty, T and G Zucman (2015) “Wealth and inheritance in the long run” in A Atkinson and F J Bourguignon (Eds), Handbook of Income Distribution, Vol 2B, Elsevier, Ch 15, 1303-1368.

Ricardo, D (1817) On the Principles of Political Economy and Taxation, London: John Murray.

Rognlie, M (2015) “Deciphering the fall and rise in the net capital share”, Brookings Papers on Economic Activity, forthcoming.

Saiz, A (2010) “The geographic determinants of housing supply”, The Quarterly Journal of Economics, 125(3): 1253-1296.

Endnotes

[1] Zoning regulations and other restrictions on land use have inhibited the utilisation of additional land in recent decades (Glaeser et al 2005). Moreover, Saiz (2010) shows, by employing geographical, satellite-generated data for US metropolitan cities, that residential development is effectively curtailed by the limited availability of suitable land.

[2] Non-residential land comprises land underneath commercial buildings, such as factory sites and office space, and agricultural land. The value of the latter (relative to income) is, however, declining over time (Piketty and Zucman 2014a).

[3] Ricardo was concerned mainly with agricultural land and the production of corn to feed a growing population.