Posts Tagged ‘price levels’

If property prices follow long-term inflation, will prices not fall in the long-term?

Monday, October 20th, 2008

Back in Do property price always go up?, we have looked into a Dutch study, which found out that in a period of more than 300 years, property prices ultimately follow the general price levels. In other words, in the long-run, property prices are flat in real terms.

For today’s discussion, let us suppose that this is true.

Does this mean that it does not matter when one purchase the property (assuming that one is only concerned about real capital preservation) because in the long-run, it will always preserve your wealth by tracking the price inflation rate? If one thinks that the answer is yes, then one has fallen into a mental pitfall called Lazy Induction. Back in Mental pitfall: Lazy Induction, we explained that

The trouble starts when the sample that we used for our observations is drawn from our own personal bias. Then, from the observations of the biased sample, we make generalisations based on our flawed observations. Lazy Induction allows us to prove anything that we want to be true. All we have to do is to pick a sample of observations that conforms to our bias and then generalise from there.

The error in the logic of that answer lies in the crucial fact that one implicitly assumes the long-term price appreciation starts on the day that one bought the property. To explain this point more clearly, we will use Professor Steve Keen’s graph of property prices relative to CPI:

ABS Established Home Price Index vs CPI

Source: Rescuing the Economy or the Bubble?

This graph shows that property prices have been tracking CPI till around 1998, after which it took off.

Now, let’s imagine that you have a time machine and travel forward 300 years. Let’s say that our assumption that property prices follow long-term inflation rate still holds true in 300 years. What will we see? Assuming that long-term price levels follow a nice gentle rise (i.e. no hyper-inflation), we will see that the prices from 1998 to, say 2008, is part of a small blip before returning to the long-term price levels.

So, what is the implication of this? If surge in prices over the past 10 years (1998 to 2008) is a huge aberration away from the long-term up-trend, then it will have to fall in due time in order to follow the long-term price levels. That is, property price can still fall a lot in real terms if it has a prior huge run-up in real prices. If price inflation is relatively benign, then this will mean a fall in nominal terms too.