Australia’s Commodity Curse and Property Paper Wealth Are a Dangerous Combination
Australia’s ‘houses and holes’ economy is what Satyajit Das called it in the Financial Times. He’s worried about how over-reliant Australia is on its two big sources of wealth — commodities and property.
I met Das at a Fat Tail Investment Research conference about 10 years ago. He blew away our audience and dominated the feedback sheets we got from attendees. If anyone ever tells you not to walk about during a presentation, tell them to watch Das in action.
Das was also kind and good fun backstage. It’s always a relief when big names are genuine. (I can confirm Nigel Farage, Mark Faber, and Jim Rickards are too.)
Today, I’d like to play second fiddle to Das’ concerns about how large a role commodities and property play. But I’d like to focus on the nature of those two sources of wealth. They’re both a double-edged sword, which means someone is likely to get hurt.
But what could possibly be wrong with a commodities boom and higher house prices? A lot, actually…
Investors love rising prices. They make us (feel) wealthier and they (can) signal a bright future to come. But today, I want to explore why rising commodity prices and soaring house prices might be an exception to the idea that rising investment prices are inherently a good thing.
Let’s start with commodities.
Rising commodity prices can be a sign of boom times to come, and they can make investors wealthier. They can even keep a country out of recession during a global financial crisis and deliver enough prosperity to make a nation the envy of the world.
But the same high commodity prices can also signal trouble. Because commodities are inputs to the cost of doing business and the cost of living.
We don’t value commodities for their intrinsic value, but for what they give us. Heat, energy, a roof over our heads, girders, cables, batteries, pipes, and hot water.
When the price of commodities rises, this makes those things more expensive. Some projects are flat out no longer viable at higher commodity prices.
While energy companies drop like flies in the UK, Australian construction companies are going under, Dutch greenhouses are going dark, and German factories are shutting down, all because commodity prices are soaring.
Sure, someone benefits from the higher commodity prices too. But it almost resembles a zero-sum game where the commodity producer’s gains are someone else’s losses. And, at some point, high commodity prices wreak havoc, as we’ve seen over the past few months.
Consider the converse example to highlight my point. If commodity prices are getting cheaper, that’s a good thing. Our technology might be improving extraction costs, for example. We might be able to get more stuff for less money.
The effect is that more economic activity becomes viable because the cost inputs are cheaper. We can build more, do more, go more places, and enjoy more stuff and experiences.
Because of these effects, deflation was the norm during some of our most prosperous periods of history, such as the Industrial Revolution. Much to the chagrin of today’s inflation targeting central bankers, I might add.
But the point is that cheaper commodities can encourage and trigger economic development. And so it’s easy to see how the converse is also true. Higher commodity prices constrain economic development, even if they do benefit some of us at the same time.
Of course, commodity prices can also rise because of high demand as the economy booms. And so higher commodity prices can sometimes be a good signal too.
So what’s the distinction? If the same high prices can be both good and bad, which is it?
The explanation lies in supply.
Normally, higher prices make more supply more viable. Farmers can grow more if agricultural futures prices are higher, uranium miners can mine more if their long-term contracts are selling at higher prices. More exploration projects can be funded for all sorts of commodities and the cut-off price for mines worth developing can rise.
But if supply is somehow artificially constrained, then a booming economy cannot make available the commodities the economy needs to grow. Higher prices are what rein in an economy to ensure resources are allocated to the most efficient uses in such a scenario. Leaving economic activity that could’ve happened in the dust.
What constrains supply? Governments do. In all sorts of ways.
Governments like to claim that they own the resources in the ground, for some reason. And they demand a cut of the profits from mining them. This adds a cost of doing business and thereby raises commodity prices and reduces our economic potential.
Governments also like to limit who can mine where over issues like climate change, the environment, and cultural landmarks — issues that go out the window remarkably quickly when the government is busy conducting business of its own, such as war.
Speaking of which, governments like to get involved in other nations’ business with dangerous alliances, sanctions, and wars. Many are fought over resource access. Both Germany and Japan used this excuse for the Second World War.
And governments like to impose all sorts of social engineering requirements on resource extractors, such as employment amongst the local population, female workforces, and engagement with locals.
Governments get involved in pipelines, ports, and shipping too. That’s been in the news lately, with Biden declaring he wants to import more oil from Canada while rejecting the pipeline, which would do so…
Last but not least, governments get heavily involved in which commodities we use. Diesel’s anti-pollution credentials, ethanol, winding down nuclear power stations early, extending the life of nuclear power stations, building new nuclear power stations, and diesel’s high pollution credentials, for example, are examples of government meddling to influence our energy mix.
Whether all this government intervention is a good idea or not isn’t my point. Not today, anyway.
My point is that government nincompoopery drives up the costs of commodities, or adds artificial shocks to commodity demand and supply, and thereby reduces the economic activity we can undertake.
Right now, commodity prices are spiking and plunging all over the place as a result of all the interventions by governments.
This is making economic activity very difficult to plan, which will in turn reduce our economic prosperity significantly over time.
The good news is that investors can offset these effects by investing in the commodity space. Heck, they might not be able to afford not to if commodity prices continue to upend our world.
Similarly, it’s quite good for Australia to benefit from a commodity boom while other nations are caught out by the rising costs. But it’s more of a hedge, because we use those commodities too. Australia’s gas shortage amidst a gas export boom is a good example of this.
But let’s move on to the second example of rising prices being dangerous — property prices.
Just as commodities are a cost, space is a cost of living and doing business too. And so, when property costs rise, the cost of everything rises.
This is most obvious in Australia, which has an exorbitant cost of living because property prices are so high. The cost of space is factored into the price of everything.
In Japan, outside of Tokyo, you can find the opposite phenomenon. The cost of living is outrageously cheap because the property price is too. Apart from restrictions on imports — another government interference — Japan has the highest cost-adjusted quality of life by far of all the places I’ve lived. (Germany, England, Ireland, Scotland, Austria, Thailand, Australia, and Japan.)
Similarly, the divergent cost of living for people in cities and in the countryside can be explained by divergent property prices.
So the lesson is that high property prices act as a drag on the economy by means of imposing artificially high costs on any economic activity.
But there are some aspects of high and rising property prices which make them even more interesting.
When property prices rise, this amounts to a redistribution of relative wealth from the renter to the owner, from the first-time buyer to the seller, and from the borrower to the bank.
None of these are healthy redistributions because the underlying asset — the property — hasn’t changed. Getting more money for the same thing is a zero-sum game.
In fact, in Japan, people see houses as a depreciating asset, like cars. And not just because Japanese houses are pre-fab, single-glazed, insulation-less boxes without any heating except in the toilet seat. Japan has seen deflation in almost all prices over the years.
This creates its own problems in the property sector, such as restricting labour mobility, because people cannot easily sell their house and move for a better job elsewhere — one of the key ingredients of prosperity is labour mobility. If Japanese sell and move, they often book a loss on the house price.
But back to rising property prices. When this happens for an existing property, requiring a person to borrow more money to buy it, it is ultimately the bank which collects the benefit of the higher price. The seller must buy or rent somewhere, after all. The net gain goes in higher levels of interest to the bank.
Remember, the house itself hasn’t changed — living standards haven’t gone up. But more of our income goes to the bank as house prices rise.
That’s not healthy for the economy. Although, you can offset the effect by owning bank shares, just as you can own commodity investments.
Normally, housing supply should correct the phenomenon of rising prices. But you’ll never guess who stands guard over house supply…
Studies of the 2007 house price crash in the US looked into the role which government zoning laws and restrictions on home building played in the housing bubble. The result was simple. Where governments had restricted new housing supply, less house prices hadn’t boomed and busted as dramatically. Supply just adjusted for the rising prices.
In Japan, which is famous for its lack of zoning and building restrictions, alongside the fact that houses only last about 30 years, housing supply rapidly adjusts for prices. This keeps housing costs low.
Of course, governments don’t stop at zoning when it comes to property. They also impact the cost of building houses by mandating all sorts of requirements. But let’s give that a rest.
My point is that commodity and property price booms are not necessarily healthy things. And we have both on our hands right now in Australia.
We’ll feel the impact for…well, forever. Redistributions of wealth, economic activity foregone, the potential for another crash in property prices to come and plenty more.
While Australia appears to be booming based on soaring commodity and house prices, don’t forget what this really means for our lives. We must also pay the price of high commodity and house prices.
Until next time,
Editor, The Daily Reckoning Australia Weekend