It’s all good in theory to oppose market regulation in the form of rent controls, capital controls, trade restrictions and so on and argue that markets should be allowed to operate unhindered. In practice though these theories bite the dust when faced with real-world constraints.
Consider the case of Berlin, which has a housing affordability problem that’s felt in both the rental and own housing markets. This is despite massive inflows of private equity investments over the last decade-and-half. The PE investments in housing have not led to the expected supply boost that might have created downward pressure on housing prices. At least not till now.
Gillian Tett has an article in FT about Berlin’s housing problem.
Since 2007, a dozen real estate investment groups — such as Deutsche Wohnen, Vonovia, Covivio and Adler — have spent more than €42bn to buy properties there. City planners hoped this would expand the housing supply. But rents exploded, tripling in neighbourhoods such as Friedrichshain-Kreuzberg and Neukölln, and doubling in outlying regions such as Marzahn-Hellersdorf. And since Berlin is a city where four-fifths of residents rent, this sparked popular anger — particularly among the young who were being squeezed out. This is not, of course, unique to Germany: as a recent FT series shows, similar stresses exist across the western world. Indeed, on average across the EU some 42 per cent of 25- to 29-year-olds live with their parents due to these pressures, says Eurostat.
But Berlin’s situation is extreme. So is the political response: in 2021 activists organised a non-binding referendum on whether the government should expropriate 240,000 dwellings in the city owned by big investment groups (those with more than 3,000 properties)… When the referendum occurred, it passed with the support of 59 per cent of voters… the activists are now planning a second — binding — referendum. If that also passes, the Berlin government may end up having to spend billions of euros it currently doesn’t have to buy apartment blocks back from property giants and bring them into public ownership…
It shows what can happen when popular anger erupts about rising prices — and corporate power… Berlin is not alone in having politicians who mutter about the need for rent controls. Similar themesare heard in the state of Washington in the US (where median rents jumped 34 per cent between 2001 and 2019) and in the Labour party in the UK (where rents jumped 8.9 per cent in the year to April). So the lesson that moderate politicians (and anxious real estate investors) need to learn from Berlin is that if they hate the idea of rent controls and/or expropriations, they urgently need to find other ways to counter the rental squeeze, most notably by expanding the housing stock.
Here are some observations:
1. Econ 101 informs us that markets will deliver the best outcomes if allowed to play themselves out. This is good in theory but struggles in practice across markets. There are at least two compelling arguments against any blind faith in markets.
One, markets can end up in multiple equilibriums depending on the starting and prevailing conditions, some very damaging. In this case, with the arrival of private equity investors, the Berlin rental housing market appears to have moved to a worse equilibrium. Second, as Keynes said, we may be dead by the time markets play themselves out and attain the desired equilibrium.
2. There’s a fundamental incentive incompatibility issue with PE investments in markets like healthcare, housing, education, old-age homes, etc. There are two features to the revenue streams from investments in these segments - stable and reasonable returns. Being essential services and serving the mass market, price reasonableness is essential in all these segments.
However, the value proposition of PE investments is to maximise profits. This pursuit of higher returns invariably drives up prices all across the housing market. Being the classic rent-seeker, the PE firm has no interest whatsoever in increasing supply at the cost of its rents. This raises fundamental questions about the suitability of PE investments in these markets. In these markets, unlike the supply of pure private goods, unrestrained pursuit of profit maximisation and corporate interests cannot be the primary driving forces.
3. This example illustrates the major faultline in the dominant American-version capitalism, of which PE is an important marker. The incentives of this capitalism and capitalists are often at odds with the overall public interest (and this happens when the balance between profit maximisation and public interest is unsettled). Further, in this version of capitalism, markets have come to be dominated by large corporates and financial market interests.
This must change. As the Berlin case illustrates, the large buyout of rental properties by PE firms has made them a lightning rod for those aggrieved by rising rental costs in a city where the vast majority are renters. With their aggressive market expansion and profit-maximising actions, the PE firms have none but themselves to blame for this discontent and its attendant consequences. It’s a case of saving capitalism from the capitalists!
4. Econ 101 informs us that market regulations like rent controls are bad. That may be so in theory. But in practice, when faced with ballooning rents arising from a combination of the market power of large PE landlords and the limited marginal supply, market regulation might be required.
Politicians facing fast-rising rents will face strong pressures to do something. Experts will tell him to ease zoning regulations and lower the cost of housing construction. They are essential for ensuring longer-term supply, but will not have any impact in the immediate or short-term. Rent control turns out to be the only lever available that will generate immediate impact.
As Jean Claude Juncker famously said, “Everyone knows what to do, but the problem is to win elections after doing it”!
5. Price controls in the housing market should be seen alongside other interventions like capital flow management, monetary policy interventions, trade restrictions, agriculture market interventions etc. In each case, the interventions are necessitated by the market failures engendered by the operations of the less restricted (or more free) markets. Such failures are inevitable given the nature and realities of these markets.
Supporters of free-market capitalism are being pig-headed in refusing to acknowledge these market failures. Instead of sticking their head in the sand, they ought to acknowledge the reality and offer technically correct but practical solutions. This will anchor the public debates on practical responses, thereby avoiding wholly bad responses and instead generating second-best solutions. Theory should not become the enemy of the practical. This might be a case of saving capitalism from the ideologues of free-market capitalism!
6. Finally, it can be argued that such market failures happen because markets have not been allowed to play themselves out. But this logic runs into the fact that markets operate in the real world where fetters and restraints against their full play are unavoidable.
The problem with this line of reasoning is its slippery slope for politicians and bureaucrats. When should governments intervene? With what instrument? How to calibrate the intervention? How to exit the intervention?
There are no easy answers to complex political economy problems. Market-driven solutions are at least no less problematic than government interventions in these kinds of markets. It can end up aggrandising a few at the cost of immiseration of the many. Against this backdrop, interventions are inevitable.
Experts and commentators should wake up to the reality of a world where market interventions are inevitable. Public debates should be anchored around those second-best interventions that generate the least distortions and inefficiencies. Public policy discussions should be conducted in this constrained space.
If rent controls have become inevitable, how best to do it? Or what alternatives can generate an impact in the short term on the housing affordability problem in the rental market?
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