The superficial appeal of the 'population growth drives Canadian house price' argument: Does it hold water?
JULY 08, 2011
It's amazing to me how often I hear this argument. If you take a few minutes and read the comments posted on, for example, the Globe and Mail website every time there is an article about house prices in Canada, you won't have to read long before you find someone advancing an opinion along the following lines:
"House prices in Canada have been rising because of rising population. Population will keep rising, therefore house prices will keep rising."
There is a superficial appeal to the argument. It would seem at first glance to make perfect sense. Rising population creates demand for housing. We aren't making more land, therefore it must result in rising prices.
Let's first address what is true in this statement before discussing the massive holes in logic. Rising population can have a huge effect on house prices in cases where that demand cannot be met. It's a classic supply-demand equation, which we will discuss in a moment. This can be true in cities with restrictive land-use regulations, or in places where demand for a particular location (waterfront for example) outstrips available supply. This can result in house prices in those areas outpacing fundamentals that govern the housing market as a whole.
Some have made the argument that house prices in some of Canada's larger cities have been driven by this dynamic. The massive divergence between house price appreciation and income growth in Toronto and Vancouver are often explained in this way. Unfortunately it's not true. While certainly some of the growth can be attributed to this, particularly in high-demand areas where new product can not be brought to market to meet demand, but as a whole, it takes a back seat to other factors in driving house prices. Let's explore this concept a little more:
1) Restrictive land-use regulations and boom-bust cycles
The work of Demographia has argued very strongly that cities with restrictive land-use policies are prone to boom-bust cycles. In large part this is due to the wide-spread acceptance of this very story that rising population = perpetually rising prices. This creates the psychology that Mark Carney warned about in a recent speech in Vancouver:
...One cannot totally discount the possibility that some pockets of the Canadian housing market are taking on characteristics of financial asset markets, where expectations can dominate underlying forces of supply and demand. The risk is that expectations become extrapolative, prompting the classic market emotions of greed and fear—greed among speculators and investors—and fear among households that getting a foot on the property ladder is a now-or-never proposition.
No one explains this concept better than Australian economist Leith Van Onselen who has created the following graphs depicting house prices in US cities with restrictive and responsive land-use regulations:
Hard to miss the boom-bust nature of many of these American cities. And by the way, in addition to classifying Toronto, Vancouver, and Montreal as severely unaffordable, Demographia also notes that all three cities have more restrictive land-use regulations:
So we can conclude that if in fact it is the restrictive nature of land-use regulation in these cities that is keeping the construction industry from bringing supply to market fast enough to satiate demand, there is still reason for some concern.
However, although restrictive land-use regulation could create boom-bust cycles in these cities, I'm actually far from convinced that it has. In fact, the whole notion that population growth has been the primary driver of house prices increases strikes me as far-fetched. This brings me to point #2.
2) The 'population growth drives house price increase' argument entirely ignores the role of supply
Here is the massive fallacy of the argument. As noted above, house prices would be expected to experience strong growth when demand outstrips supply. But that argument cuts both ways; House prices should experience weak growth when supply outpaces demand.
It is supply and demand, and anyone who blindly accepts the 'population growth = perpetually rising house values' argument is accepting an idiom that turns a blind eye to an entire half of the supply/demand equation. Let's not do that!
As Don Campbell would say, let's do some meme-busting research. Let's start with some facts that have already been discussed here before: House prices and population growth, have an exceptionally weak correlation:
As do house prices and growth in immigration:
In fact, we don't need to delve into mathematical correlation to see that the relationship is pretty weak. Here we see house prices, population, and total immigration all set to 100 in 1980. There is no pattern whatsoever:
The bottom line is that Canada's growth rate has been remarkably boring over the past several decades. One would expect that if population growth has driven the past decade of exceptional house price gains, we would see a spike in population growth. Not so much:
And yet we are led to believe that this boom in population has led to this:
Clearly a weak argument. But we're not done yet.
Let's revisit a key concept: If demand outstrips supply, as the 'population growth = perpetual house price increase' argument holds, and if this is leading to house price increases, then the opposite must also be true. Let's see the data on this one.
To measure the accuracy of this statement, I have obtained household formation data from the Conference Board of Canada. I have compared it to housing starts from CMHC. Household formation is simply an estimate of the number of households that require new homes. Housing starts are the number of new homes that have started construction. If the argument holds water, we should expect that during times where housing starts (supply) exceed household formation (demand), there should be downward price pressure, while periods where household formation (demand) exceeds housing starts (supply), prices should experience stronger gains. But is it true? Let's look at Canada as a whole, and at the four most populated provinces.
I think we've seen enough to recognize that something else is at work here. The argument that population growth causes house prices to rise indefinitely misses the massive factor of supply. Let's face it: In the majority of Canadian cities, even the large CMAs, there is no shortage of building opportunities. This argument is wholly insufficient in explaining the unparalleled real house price increases of the past decade.
Here's your real culprit....and this baby's not sustainable: