Housing prices in Amsterdam, corrected for inflation, have never been this high since recorded history. Beside the low interest rates, the reason for the rapid rise in prices is the feedback cycle between banks and consumers who have become addicted to mortgage lending and the ever-increasing prices.
With the Great Financial Crisis – caused by the real estate bubble – still fresh in our memories, in many advanced economies home prices are currently rising at a record pace. House prices in the Netherlands increased by 19% in the third quarter of 2021 compared to the previous year.
Some economists see housing prices in Amsterdam – which has had its longest index – overstated since 2020, based on a model of rents and interest rates. Others point to policies implemented in the West over several decades that have created a “housing finance feedback cycle”, with banks becoming addicted to mortgage lending, driving up home prices, and consumption increasingly dependent on the “wealth” generated by rising prices. As this trend causes banks to lend less to productive businesses, the core of economies is weakening.
Longest-Living Real Estate Index
Many of the building blocks of capitalism were invented in Amsterdam, the capital of Holland (Netherlands). In the late 16th century, the Dutch embarked on trade campaigns across the sea to Asia. By 1600, six “East India” start-ups were sailing from Dutch ports. To combat Spanish and Portuguese competition, and not to compete with each other, the six existing companies merged into one: the United East India Company (united east india company, or VOC for short). Officially licensed in 1602, VOC became the first joint stock company, with its shares being traded on the first stock exchange. Money from all over Europe flowed into the Netherlands. Because of the extraordinary success of the VOC, Amsterdam needed to expand, and it did so by digging three canals around the medieval city center: HerengrachtAnd Keizersgracht, And Prinsengracht.
Herengracht real estate transaction prices, which are the best ever, have been carefully recorded. In 1997 the Dutch economist Pete Eichholtz set the Herengracht house price index with consistent quality from 1628 until 1973. This was the birth of the Herengracht Index. Eichholtz’s preliminary research showed that real housing prices (corrected for consumer price inflation) gradually changed over time, but were more or less equal in 1973 compared to prices in 1628.
Eichholtz et al published an update of historical housing prices in Amsterdam in 2020. For this publication, Eichholtz et al collected a deeper set of data, which begins in 1620 and includes homes from a wider area. Although the numbers indicated that prices began to rise significantly from the 1990s onwards, their conclusion was that the housing market was not in a bubble, based on rental rates and interest rates.
Mathijs Kurivar, one of Eichholtz’s colleagues, was very kind to provide their data until September 2021. In an email he wrote to me that after 2019 prices had gone up to the point that their model indicated that real estate in Amsterdam was now overpriced. Below is a chart of real housing prices in Amsterdam from 1620 to September 2021.
What happened in the 1990s that drove home prices so much higher than during the Netherlands’ golden age in the 17th century and the second golden age in the late 19th century? To gain a broader understanding of the housing market—beyond the model based on rent and interest rates—read the work of an economist specializing in land, housing, and banking: Josh Ryan Collins.
The mortgage revolution
According to Ryan Collins, there have been two major developments in the housing market since the 19th century: a change in the land tax and the deregulation of fiscal controls. Although he was mostly researching Anglo-Saxon economies, I reviewed his findings in the Netherlands.
Classical economists, such as Adam Smith and John Stuart Mill, viewed land as an asset incomparable with other assets, mainly because it is in fixed and immobile supply. If the demand for land increases, the price rises without the increase in supply. As a result, if there is economic growth, the value of the land – on which homes are built – rises disproportionately with goods and services (even if the landowner plays no role in creating that value). Smith and Mill’s solution was to tax land, rather than tax labor or profits. In fact, in the 18th and 19th centuries, the land tax was a major source of income in the United States and Europe.
Then came the neo-classical economists who dumped the above-mentioned theories on the ground. In the twentieth century there was a shift from land tax to income tax. Owning a home as a financial asset is becoming more and more attractive. All that was missing was a way to finance real estate.
From the 1930s through the 1970s, governments in most advanced economies imposed “credit guidelines” on banks, which restricted mortgage lending. By preference, banks lend mortgage credit over corporate credit, since the former is less risky. A home purchased with a mortgage is usually a safe guarantee of the loan. In the event of bankruptcy of the borrower, the bank can obtain the guarantee and the damage is limited. In the case of lending to a company, there can be no collateral or guarantees of low quality. But for society, lending to productive firms is essential, as it creates sustainable economic growth and debt-servicing income. But credit guidance was slowly dismantled, as a result of which mortgage credit to banks exceeded non-mortgage credit in 1995. The mortgage revolution was a reality.
The bank produces money out of thin air when it lends credit. Therefore, in the case of banks lending mortgage credit, the money supply is expanded, but the money is spent on a limited amount of houses. money supply flex, while the supply of homes not flexible. No wonder home prices skyrocketed in the 1990s. Subsequently, the cycle of feedback on housing finance began: the rise in housing prices increased the demand for mortgages, which led to an increase in prices, which led to an increase in the demand for mortgages, etc.
Mortgage securitization, which took off in the 1990s, also contributed to the “cycle.” Securitization enables banks to bundle mortgages and bundle them into a mortgage-backed security (MBS). An illiquid asset (mortgage) is converted into a liquid asset (MBS) that can be sold, for example, to a pension fund. Banks get a fee for selling MBS, and when the securities are off their balance sheet, they leave more room for new mortgage lending.
Last but not least, the capital controls that were lifted after the Bretton Woods collapse in 1971 meant that banks could no longer rely on local deposits for their financing. Banks have access to international money markets, where they can attract additional financing for housing credit.
Rising real estate prices cause the home price-income ratio to rise and thus reduce consumer spending. This loss of spending in a housing finance reaction economy is offset by the “wealth” generated by rising home prices. People with unrealized gains on their property will spend more because they feel richer (wealth effect), or take out a second mortgage to buy a boat (capital withdrawal). Others’ profits increase by speculating on real estate. But consumption can only continue as long as the cycle continues.
The cycle needs more debt and higher home prices. This spiral of unsustainable debt continues thanks to the blessing of central banks that have lowered interest rates. In my opinion, the above is like a Ponzi scheme and the housing market is in a bubble. Although I am not sure how long this situation will last and how the bubble will pop. Nominal home prices may fall, inflation may rise so that real home prices fall with their long-term average. The problem with low nominal rates is that it can bring down the banking system, something central banks want to prevent, as banks are highly exposed to mortgages.
I would like to stress that not every (advanced) economy has the same housing market. Mortgage debt levels are not rising linearly. After the Great Financial Crisis of 2008, home prices and mortgage debt levels declined in many economies. In response to the crisis, governments bailed out banks and bolstered the economy – leading to an increase in government debt. The housing bubble has not been allowed to fully deflate. Interest rates have reached zero, real interest rates have fallen, and the cycle has been reactivated. Home prices have resumed their rise.
Furthermore, an academic paper (“More Mortgages, Less Growth?”) from 2016 by Dirk Bezemer et al states:
In the newly collected data on 46 economies over the period 1990-2011, we show that the financial development since 1990 is mostly due to the growth in credit to real estate and other asset markets, which has a negative growth coefficient. …we found positive growth effects for credit flows to non-financial businesses but not to credit flows in mortgage and other asset markets. …
Not only did the mortgage revolution “crowd out” the credit of productive companies, the flow of credit into mortgages had a negative effect on growth.
Could it be that the mortgage revolution, which stifled growth, combined with a legal international monetary system that allowed unlimited debt levels, had generated the largest debt trap in world history?
Finally, in the Netherlands, and I suppose elsewhere, the most frequently mentioned solution to unaffordable housing is simply to build more houses. This approach failed, because banks could always print money faster than anyone could build homes. The solution must be found on the demand side, not the supply side.
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Tax and Customs Museum. A digital journey through the history of taxation in the Netherlands
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