The wonderful thing about a free-market in action is that price changes have a causal effect on supply and demand. While many markets, especially the residential property market, are grossly inefficient, subject to government intervention and misrepresentations from vested interest groups, eventually, prices will return to their intrinsic values.

In recent years, the residential housing sector has experiences a dramatic increase in price. The oft-stated rationale for the house price inflation was due to an alleged housing shortage, which was caused by a combination of immigration, higher birth rates and reduced construction activity. The quantum of the price rise has been significant. The critical guide of housing price levels is the ratio of house price relative to disposable incomes — this measure has seen house prices (compared to income) double in little more than a decade. Prices have also increased in real (inflation adjusted) terms — as Steve Keen’s graph below indicates, since 1996, house prices have risen at double the rate of inflation:

100518_houses_infl

But as this column noted last year and any basic economics textbook would instruct, in a functioning market, prices will provide signals to consumers to alter their demand and to producers to increase supply.

As Keen pointed out in Business Spectator the so-called housing shortage has only materialised in the past 2-3 years — between 1986 and 2006 the rate of dwelling construction easily exceeded the rate of population growth.

But while the alleged shortage is probably an irrelevancy in any event, it appears that even the mythical shortage probably won’t last too long. Already, housing approvals have increased sharply in recent months, with the ABS reporting that approvals rose by 15.3% in March, hitting their highest level since October 2003. Based on recent figures, about 170,000 dwellings are forecast to be constructed this year — providing shelter for around 440,000 people (less the effect of dwellings that are being replaced).

But not only are developers rushing to cash in on the higher prices, but the lack of affordability is causing politicians to re-think Australia’s heavy immigration policy (voters who can’t afford to buy a house may be disinclined to vote for the party that played a significant role in the house price appreciation). Fairfax noted a report (released yesterday) from forecaster BIS Shrapnel which stated:

“Breakneck pace of population growth over the past few years can be explained by an unusually large rise in long-stay visa holders such as foreign students and 457 workers.”

However, a slackening in the jobs market and a slower pace of enrolments by foreign students is expected to mean this one-off bulge in numbers will pass through.

In total, BIS expects immigration to fall from 298,900 this year to only 145,000 in 2012. If those predictions eventuate, it seems like Australia’s great housing shortage will turn into a massive housing surplus with thousands more dwellings being constructed than is necessary to match the population rises.

Combined with increasing interest rates (as the cost of money returns to a more reasonable level), it appears that the market will be belatedly doing its job, proving the adage, the solution to high prices is … high prices.

Australia’s housing bubble has led to politicians reducing immigration levels, developers increasing construction to cash-in on higher profit margins and the cost of borrowing increasing — all symptoms of a functioning market in action.

Incidentally, clearance rates in the large Melbourne and Sydney markets have been dropping alarmingly in recent weeks. According to Australian Property Monitors, Melbourne’s clearance rate has dropped to about 70.3% (after being above 80% for most of 2009) while Sydney’s clearance rate has sunk to 64.9%.