Wednesday, 23 September 2015

GDP transactions in secondary markets

There is a widespread view that much bank lending is unproductive, i.e. does not raise GDP – or if it does, it does so in an unsustainable way by inflating asset prices or increasing inflation, rather than by increasing production.  Many proposals for bank reform therefore envisage restricting banks to “productive” lending, by which usually seems to be meant business finance and short-term consumer credit. Financial transactions on secondary markets, and the purchase of second-hand property, are regarded as unproductive.

This appears attractive. Banks do indeed lend far more for property purchase than they do for business finance, and most of the properties purchased are second-hand. So, the thinking goes, if we could eliminate unproductive housing finance, banks would lend more to businesses, and that would mean higher GDP in the longer term.

But I’m afraid there is a serious fallacy here. Lending for secondary market purchases does contribute to GDP, and not just in unhealthy asset price inflation. Without secondary markets, primary markets are diminished, and – by extension – so is GDP.

Here is an example. Suppose I buy a brand-new house off plan. Clearly, the building of my new house employs a significant number of people in various trades, who collectively create a “product” – a house - so my purchase is a GDP transaction. The bank that lends me the money to buy my house has therefore lent productively. Few in the UK would disagree with this. But in Spain or Ireland they might see things differently: after all, building houses there became a wholly unproductive activity prior to 2008.

But suppose I buy a listed building with no roof, rotten floors, shattered windows and holes in the walls, which I then restore for subsequent sale?  For the restoration, I employ a significant number of people in various trades, who collectively create a “product” – a refurbished house – that can be sold for a much higher price than the original dilapidated shell. Clearly, this contributes to GDP. It also brings into use a house that previously was not suitable for habitation. Please tell me why the borrowing to finance this should be regarded as “unproductive” when the borrowing to buy a brand-new house is not?

Perhaps, though, this is too obvious an example. Suppose I buy a house owned by an elderly lady who has lived there for 50 years. The house is not in poor condition, but the décor is not to my taste and it needs modernisation. I could do it up gradually, paying for improvements entirely from earned income. But I choose to front-load the upgrade by taking out a Home Improvement Loan. This is consumer credit that I would not have taken out if I had not bought the house. Because I borrow to do up the house, I provide employment to assorted tradesmen, revenue to the suppliers of kitchen & bathroom equipment and income to the staff on the tills at B&Q. And when I have finished decorating, I buy new carpets and furnishings, probably also on consumer credit. None of this would have happened if I had not bought the house. So although buying a house in good condition on the secondary market does not itself contribute to GDP, since the house was built long before I was born, the things I do after buying it to make it a place I like to live in do contribute to GDP. Is financing a secondary market house purchase of this type “unproductive”? I don’t think so.

In fact most people purchasing second-hand houses decorate and refurnish them, and most do so using consumer credit. The second-hand housing market gives considerable impetus to GDP through these consequential transactions.

And there is another side to this. What happens to the money I pay to buy the house?

In my first example, I pay a deposit up front, and my final payment when the house is completed and all snags resolved. The money goes to the builder, who pays down the loan he has taken out to fund the building of the house. So the money I borrow simply refinances the builder’s loan. Is this a contribution to GDP? No. It is the original builder’s loan that contributes to GDP. My subsequent mortgage does not, directly – though without people like me borrowing to buy houses, builders would quickly default on their loans, as Ireland’s banks discovered.

In my second example, I pay for the shell house up-front. The person I buy the shell from, hugely relieved to have got rid of the unproductive millstone round his neck, splashes out some of the money on a much-needed holiday in the Seychelles, and uses the rest to buy a brand new top-of-the range BMW. Does this contribute to GDP? Clearly yes, though the holiday mostly contributes to the GDP of the Seychelles and the BMW to the GDP of Germany. So my shell purchase is productive in more ways than one.

In my third example, the elderly lady is going into residential care, and the money raised from the sale of her house will go towards paying for her care. The sale of her house therefore funds employment in the care sector, which contributes to GDP.

But even if my elderly lady were only buying a retirement flat, the transaction would still contribute to GDP, since my house is worth more than her retirement flat and she can use the difference to top-up her consumption spending.

So secondary market purchases of property DO contribute to GDP, in lots of ways. In fact the refurbishment example is the most GDP-enhancing of these purchases, and the elderly lady example is arguably the most socially useful. Surely the lending to finance these should be regarded as "productive"?

All secondary market transactions are potentially GDP enhancing. This is because of their “pull” effect on primary markets. For example, consider someone who owns a 5-year-old BMW. He wants to buy a brand new car, but he needs to sell his current one in order to afford a new one. So he trades in his car. If there were no secondary market for cars he would be unable to do this: he would drive his BMW until it fell apart, rather than buying a new one every 5 years. True, car manufacturers might respond by cutting the prices of new cars to entice purchases, and they might run a scrappage scheme for cars older than 5 years: but could this really be called “productive”?

As a general rule, when there is no secondary market for long-dated assets, the issue of new assets in that class is limited by the availability of new entrants to the market and the expiry of existing assets. Secondary markets are essential to maintain liquidity: restricting finance for secondary markets actually diminishes, rather than increasing, primary market activity.

So the idea that secondary market purchases are “unproductive” is thus incorrect on many counts. Restricting finance for secondary market purchases, whether cars, houses or financial assets, puts downwards pressure on GDP.

Related reading:

Ann Pettifor, there will be no shortage of money - Positive Money
Quantitative Easing and the Quantity Theory of Credit - Richard Werner
Co-op community marks 30 years of building a better life - Co-Op News

This post was prompted by a discussion on Twitter about what "lending for GDP transactions" really means in practice. It first  appeared as a guest post at RWER


  1. I agree with the above article. But there’s actually an additional argument that can be put to back Frances’s conclusion. It’s as follows.

    Frances concentrates on the various ways in which much of the money borrowed and spent on buying an existing house, often ends up being spent (e.g. the pensioner who sells a house and uses the money to boost retirement income). And that’s a reasonable point.

    But to the extent that the proceeds of a set of loans do not get spent, does that really matter? Well it might seem that it matters because loans have not increased GDP by as much as is needed. However (and this is the big flaw in the “GDP increasing” argument) to the extent that borrowed money is not spent, no inflationary pressure derives from that loan, thus a further (and GDP increasing) loan can perfectly well be made (or government can implement stimulus in some way, e.g. an increased deficit).

    In contrast, had the initial loan given a big boost to GDP, then the second loan would not be possible (or it would have to be smaller).

    To illustrate, suppose the economy has £Xpa of spare capacity and a £Y “GDP increasing” loan would bring the economy up to capacity. Does it matter if someone gets a £Y loan which fails to increase GDP at all? No it doesn’t! Reason is that there’s nothing to stop a further £Y GDP increasing loan being made.

    I set out that argument here:

  2. But is the escalation and continued elevation of asset prices unproductive?
    If house (LAND) prices were lower could more of the available (proportion of income) loan to purchase be spent on new materials and labour to get stuff done?

    It also begs the question as to whether GDP growth should be the focus rather than trying to give everyone who wants one a home and a job.

    1. I did in fact focus on employment and shelter in this piece, Danny, rather than on a simple measure of GDP. The first two examples (building a new house and restoring an old one) are actually equivalent in terms of employment and shelter: in each case a house is made available for habitation that was not previously available, and in each case there is employment for tradesmen. The third example does not create more shelter, but it distributes shelter better - since it enables my elderly lady to move into her care home or retirement flat - and it generates both employment for tradespeople (when I do up the house) and employment in the care sector.

      Simple focus on rising asset prices as "unproductive" misses all of these consequential effects.

      I should add that builders will not build into a falling market. Nor will people do up houses if the price is falling sharply. Wealth effects matter.

    2. Your descriptions of productive activities on the bricks and mortar are very clear. However the bricks and mortar are only one part of real estate values the other part being the land value. Housing stock is largely fixed so looser lending on real estate will tend to elevate land values. It is my contention that increasing land value is un(anti)productive. After all this is the mother of all economic rents, increasing the costs of doing anything. As you point out developers will not build in a falling market, this is because they have become more land speculators rather than builders and a falling real estate market is down to falling land values, the material and labour costs are stable by comparison. I think we as a society need to get better at separating out the wealth effect from land values which represents transfer payments rather than new wealth.

    3. Ah, I see where you're coming from now. Yes, I agree. Separating land value from the value of the property built in it (which should depreciate) makes a lot of sense. Land is a safe asset, but shouldn't be a speculative investment with its value driven up by protectionism, blatant market rigging and artificial scarcity. My concern here though is that restricting secondary market finance for property purchase does not address the real issue and tends to depress GDP. Å land value tax would be a far better alternative, I think.

    4. "Land is a safe asset, but shouldn't be a speculative investment with its value driven up by protectionism, blatant market rigging and artificial scarcity. My concern here though is that restricting secondary market finance for property purchase does not address the real issue and tends to depress GDP. Å land value tax would be a far better alternative, I think."
      Frances, arguably land prices is driven up by lending. I am not a fan of Positive Money, but this is a good graph showing it:
      On land/location, my view is that it is a monopoly. As a young person disadvantaged by the current system, I support 100% LVT/govt nationalizes all the land. The land value is created by all of us via infrastructure, good schools/hospitals, location, natural features, etc. So those who wish to exclude others from the land should pay for the privilege.
      Just as a monopoly water company's' shares may be widely distributed, land can too, but it is still a monopoly.

    5. FC
      Your comments about land value tax are a trifle superficial given that Adam Smith,@JS Mill regard it as essential to a free, laissez faire economy.Without it,as the title of Henry George's best seller made clear, commercial Progress will only lead to Poverty if the increases in available money just put up land values ,then housing and business costs, decreasing demand for goods and services produced by human industry in all senses.LVT is not just a useful clip-on to an existing tax system, as you imply, but a whole new system with different notions of value. The deliberate tax privileges for landed wealth, used as bribes by the UK political parties, are producing a nouveau rentier economy where the younger generation has to pay a private tax for scarce location advantage .As the world economy collapsed in 2007 due to a property bubble burst which undermined banks' securities, some anger or at least urgency would be more in order on your part ,rather than this come day, go day attitude.

    6. Really don't think the critical tone of your comment is appropriate given that this blogpost is not about land values but about the relationship of secondary markets to GDP. Neither this post nor my comments here tell you anything at all about my views on land and property bubbles.

    7. You are saying that your approval in your post of three specimen property deals and their financial backing, which you see as productive, without any mention that the purchase prices are enormously inflated by land prices says nothing about your views on land and property bubbles? Investing in land cannot be productive because it does not produce any more land. It is no good now reining back the property market is the people's friend stuff now by later making vague gestures in the direction of LVT: the logic of LVT undermines your three illustrative cases and , hence,your entire argument for the productive role of investment in this market.

    8. You haven't read what I said properly. My examples made no assumption that property prices would rise except as a consequence of labour effort. The points I made about consequential transactions would still be valid if prices were static.

    9. Capitalised land values are inherently parasitic and so therefore is any interest derived from them.

      If the examples you gave only occupied marginal locations, you'd have made a good point.

      But, as we know most housing, particularly in the UK occupies valuable locations. Hence bank lending on mortgages is harmful in the short term and always leads boom/bust cycles in the long term.

      In Spain, Ireland and the US, planning regulations certainly could not have been the cause of their housing bubbles.

      Although I'm sure the anti-planning fanatics at the LSE would try to argue differently I dare say.

  3. Consequential effects matter, but are thin gruel. Once banks were free to accommodate the increased demand for credit arising from secular changes in work patterns (post consumer and credit control 1971) real prices for houses v wages are x4. This did not create a private sector building boom, rather land hoarding. So my polish plumber lands a job, but demand is sucked away from other areas as a greater chunk of wages goes to rents and repayments. Surely this effect must contribute to the falling rate at which broad money growth increases GDP.

    1. Demand is demand, Hugo. Demand simply diverted from one area to another doesn't increase GDP. So you have to ask yourself why reducing secondary market transactions would increase demand. It is not clear to me that it would.

    2. Your point that demand exists in the secondary market and is alike to any other demand, I accept. My point is that in the case of a secondary market in housing there are possible effects on overall effective demand due to the long term change in household portfolios, arising from both the higher mortgage debt and the higher price level. Rents and instalments sent to pay down loans are lost to demand, just as the leakage on the current account is lost to overall demand. Clearly there are distributional wealth effects for those that bought earlier, but do those offset the loss to those coming in now?

    3. Follow the money, Hugo. Rents and instalments paying down loans are not lost to demand unless bank lending shrinks.

  4. GDP rises no longer increase personnel consumption.
    GDP is now effectively depreciation of capital goods.

    UK domestic energy data is now quite striking.
    People are better off living in larger family groups or as lone hobbits divorcing themselves from utilities and other rentiers as much as they can.

    The function of production / consumption is not to create work.
    The function of production is consumption.

  5. Consider a extended family with adequate savings and or purchasing power and just as important abundant time units.
    In many cases they can look after the sick and elderly at home.
    This care does not add to GDP........but the family is wealthier in human terms.

    Just remember in many cases (perhaps until the terminal phase) the elderly go into residential care because the family unit no longer exists. (As a result of capitalist stress)
    This structural deformation of the human condition so as to facilitate rising debt dynamics and thus international bond holders is beyond sick.

    First consider what real humans (not exposed to liberal materialism)want and need .
    Not what the usury class want us to do so as to aid their concentration schemes .

  6. The points are all well made, but a lot would seem to depend on the detail. If banks lend into the secondary real estate market at variable rates, will this not exaggerate the tendency to asset booms ? Those with capital want to park it. If lenders think their returns will get back to "normal" when central bank rates rise, have you not removed the last dissuasion?

    1. Simon,

      No. Remember that banks make money on the spread between lending and funding. Variable mortgage rates are quoted as base + margin, "base" being the Bank of England's base rate (which is the banks' lowest cost of funds) and the margin being the spread that the bank wishes to earn over the base rate. The margin is set when the loan is granted and doesn't change: when rates rise, only the "base" portion changes. So higher rates make no difference to a bank's earnings from existing variable rate mortgages. Only if mortgages are refinanced can a bank change the margin.

    2. Thank you for your reply, but I'm afraid that just pushes my question back to wherever the funding is coming from. Someone is getting to park capital in "safe" unproductive assets with low returns for a period they hope will be short. Would their decision look different if today's low rate was locked in for 20 years ? I'm writing from France, where 25 year fixed rate mortgages are currently around 2,2%. Lenders don't seem to expect "normal" returns anytime soon.

      I seem to be obsessing on this point, so I would greatly appreciate your putting an end to my misery !

    3. This comment has been removed by the author.

    4. Is that statement correct, that the Bank of England Base rate is the banks lowest cost of funds. Is it the lowest or highest. Highest with deposits and loans from other banks lower.

    5. Base rate is banks' lowest cost of funds. Loans from other banks are priced at Libor, which is slightly above base rate.

    6. Simon, fixed and floating rate mortgages are priced differently. Fixed rate mortgages cost banks money if rates rise, just as they do households if rates fall. They therefore have a risk premium that is absent from floating rate mortgages, so are typically more expensive.

      Low interest rates are awful for banks, but that is because of flat yield curves.

  7. Building houses in the UK only appears to be productive because the kids from Ireland and elsewhere continue to flock into England in search of purchasing power.
    You are simply witnessing a artificial demand signal.

    England is a money illusion without the resources .

    If you want to free up resources scarp the carbon tax
    now cheap coal can be used to heat the existing stock.
    At the moment this is clearly not the case.
    These units have massive running costs at the moment.

    Renewables are not cutting it.
    For example despite massive growth home produced electricity still remains less then 1% of total.(DUKES)
    The capital costs are racing ahead of this meagre production.

  8. All the transaction that create new VA is included in GDP. If you make reform in your house that increase in its value, that is included in GDP. The unique problem is to get the statistics source, but conceptually there is no problem.
    The primary source is obviously the contract between the proprietary and the firm in charge of the amelioration. If both parties don't declare it, ther is no direct source to know the exact a lie of transaction.
    So, National Accounts use judjemental criteria as as an imperfect but second best.
    There is a lot of transactions with VA included at judgmental criteria in GDP because there is no other source.
    But if I buy/sell a house in the secondary market, with huge increase in price, that mus be no included.
    So ther is no a problem of methodology.

  9. So, You haven't much idea what you are talking about

  10. Blaming secondary markets is silly, but I suspect there's an underlying problem here that might be better understood if we split the value of the house-as-object and the land-it-sits-on.

    Let's imagine we get a tech that allows moving housing machines very cheaply ("everybody living in caravans"). For simplicity let's further assume the tech works on the entire existing housing stock (all Victorian terraces suddenly have wheels).

    Housing machines could then be priced separately from lots you put them on. No doubt the market for housing machines would then become like any other "kit" market, with the bulk of the second hand stock apart from a few antiques priced off and below the factory gate price of new ones. I don't think anyone would see an objection to that.

    We could then see how much of the bank lending goes to the zero sum game of trading trailer park slots (whose supply is more or less fixed as long as government keeps the acreage allocated to housing lots fixed). Given the "factory gate" price of a typical new UK house is about £60K if I recall, that is likely to dominate the problem.

    1. Yes, I agree. Buying a house is fundamentally consumption. not investment. That applies whether the house is a new build, existing stock or - as you suggest - a mobile home. Separating out the land value might make this clearer.

  11. The criterium to include or not a transaction in GDP is not producrivity. It is Value Added. VA in each of the chain of transaction from crude materials to final product. GDP is the sum up of all Values Added. Form this magnitude, we obtain the distribution of it between profit and salaries (apart the taxes on production: VAT). The rest of GDP is the income on property, loans, etc.

  12. GDP cannot include capital revaluation. Any transaction in secondary market with a revaluation of price is a surplus for the seller and a equal loss for the buyer.

    1. Same mistake as DBC Reed. I have made no mention of property price revaluation. I am only concerned in this post with consequential transactions arising from property sale/purchase, not with the property transaction itself.

    2. The mistake's yours.You are laying down the law for an imaginary world where there's no revaluation through land price inflation .Its perfectly easy to prove a point if you define the terms of the discussion yourself excluding awkward reality.It is the Economic schism of the Sorbonne students in 2000 when confronting Autistic Economics (their unfortunate term).

    3. No mistake. I could just have easily have discussed the effect on GDP of the used car market, or my local flea market, or the market in second-hand corporate bonds (which is significant). The point which you seem to have ENTIRELY missed is that secondary markets are necessary for primary markets to function properly. They spark a chain of consequential transactions that contribute to GDP. The inflation of land prices has nothing whatsoever to do with this and I therefore did not discuss it. I have, however, discussed it in previous posts both here and on Pieria.

    4. You set out to attack "the thinking" (that)" goes if we could eliminate unproductive housing finance, banks would lend more to businesses and that would mean higher GDP in the longer term"
      Most people on here have correctly identified as "unproductive" the £100,000 a time in the" housing finance" that goes into inflating the market for residential building land.You imagine that there is some other reason why buying and selling second hand houses is considered unproductive and demolish this straw man argument, to the evident dissatisfaction of the younger people making comments.Do you really think that the effect of the land-based housing market on GDP is essentially the same as the market for used cars?Your argument is ,in that fine old phrase, too clever by half.

    5. Housing finance is productive for the reasons that I gave. That would be true even if land value gains were taxed at 100% The consequential GDP-enhancing transactions would all still occur, secondary market purchases would still create liquidity for the primary market and some forms of housing finance would still be socially useful. For example, my elderly lady, who paid for her house over 25 years and maintained it for 50, does not have to have benefited from land value inflation. She could simply recover what she paid for her house in the first place.

      It is not me who is creating a straw man.

    6. I am afraid your economic logic escapes me in the tangle of your syntax. In what circumstances does the elderly lady end up" simply recover(ing) what she paid for the house in the first place": the real UK or in some economic model ?
      Please show the link with what you say in the entry above (about 300 years of yields) that there is at present a drain from workers to rentiers N.B the simplest rents on land are excluded from your analysis when they are inflationary.

    7. This is a post about secondary markets. It is not about housing in particular and it certainly isn't about land values. I am more than slightly tired of being criticised for not having written the post you would have liked me to.

      There is no link between this post and the one about 300 years of yields.

    8. Your post WAS about housing in particular with three carefully worked examples of different house purchases; there was mention of secondhand cars at the end. True, is not about land values: this is what's wrong with it,because, unlike prices of cars, house prices incorporate a great deal of land value which is why a lot of people focus on this aspect, suggesting a) cutting the free flow of bank- created money or b) blocking it with a land value tax.You have missed the major point ENTIRELY while concentrating on minor cases.

    9. "Housing finance is productive for the reasons that I gave. That would be true even if land value gains were taxed at 100% "

      No, that would ONLY be true if.....etc, etc.

      As location values make up 2/3 on average of selling prices in the UK, any discussion on housing (even if illustrating a point about secondary markets), is primarily one about land.

      Ergo, your point is only true when talking about the tiny minority of housing occupying marginal land..

      You'd have been better off defending ticket touts than mortgage lending.

    10. DBC Reed, my post was not fundamentally about housing. That you still insist that it was, despite everything I have said, indicates either that you are massively obsessed with housing or that you don't understand anything about markets. Have a look at Tyler's comment. He gets it, absolutely. You don't.

      Ben Jamin', you also have not understood the post. My point applies to all housing, not just housing on marginal land.

  13. I agree with the article but would add a point:

    A lack of a secondary market actually makes the primary market less liquid - to the point that the primary market transaction might not happen at all.

    For example, would you buy a house knowing that it would be hard or impossible to sell? it's a big investment and the risk of having much or all your equity locked into something you can't get out of will often mean that better alternatives exist.

    It's easy enough to see this effect in real life - NIMBYs - whose property becomes devalued or at least incredibly difficult to sell when a rail line or road is placed nearby. Why? No liquid secondary market exists, and the follow on is that new investment in that area becomes harder to come by.

    1. That is an excellent point. Free markets are not necessarily efficient ones.

      Take your example. Now imagine a how a land tax, by making the market optimally efficient sorts it out automatically.

      In effect, a land tax internalises all the spatial and economic externalities that gives land it's value.

      So, while a railway that lowers land values ( or in most cases like Crossrail raises then), under a LVT the tax liabilities get lower, so the selling price of land stays the same (theoretically zero).

      Thus NIMBYs, and all freeholders pay compensation, or are compensated automatically via the market.


    2. Even with a 100% land tax a secondary market would be necessary for the primary market to work. LVT is not a panacea.