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castle - Economist.com Page 1 of 5 Castles in hot air May...

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Castles in hot air May 29th 2003 From The Economist print edition Is another bubble about to burst? THE rapid house-price inflation in many countries over the past few years is clearly unsustainable. But will house prices just flatten off or will they slump? Alan Greenspan, who criticised the stockmarket's “irrational exuberance” long before that particular bubble was fully inflated, is more sanguine about American house prices. He accepts that there are local hot spots, but dismisses the idea of a national housing bubble that could harm the whole economy if it bursts. In other countries where house prices have been rising, many analysts also pooh-pooh the idea of a bubble. They point out that interest rates are low, so people can afford to borrow more and are therefore willing to pay more for a home. The affordability index—mortgage-interest payments on an average-priced home divided by average income—is still quite low by historical standards in most countries. There is something in this. First-time buyers who previously could not afford the typical mortgage payment can now get on the first rung of the property ladder. This pushes up effective demand and could possibly lift the equilibrium level of house prices. However, the cruder—and more widely used—argument that lower interest rates make homes cheaper to buy is badly flawed, because it ignores inflation. If interest rates are low only because inflation is low, then although initial mortgage payments are smaller, the real burden of mortgage debt will be eroded more slowly over time, and payments will remain high in relation to income for much longer. Lower inflation shifts the profile of payments over the life of a loan—you pay less in the early years and more (in real terms) later on—but the total real cost is the same. Home-buyers who think that low interest rates make buying a house cheaper are suffering money illusion. It is as foolish as thinking that a car loan paid off over five years is cheaper than one paid off over only two years. Lower real interest rates, after allowing for inflation, would indeed reduce the true cost of buying a house. But in many countries real rates are not particularly low, and tax relief on mortgage payments also becomes less generous as nominal interest rates fall. Sabina Kalyan, an economist at Capital Economics, a London-based consultancy, calculates that real after-tax mortgage rates in Britain (where tax relief has been scrapped) are now much higher than they were in the 1960s and 1970s, and only marginally lower than in the 1980s and 1990s. And even in countries that still enjoy tax breaks, such as America, real after-tax mortgage interest rates have probably increased over time, because the size of the tax benefit shrinks with falling inflation. For instance, if interest rates are 10% and inflation 8%, and your marginal income-tax rate is 40%, then the real interest rate you pay is minus 2%. With 4% interest rates and 2% inflation (ie, the same pre-tax real interest rate), the real after-tax rate is plus 0.4%.
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