Many readers, not all, will be familiar with the Herengracht chart shown above. As Wikipedia explains, the index – of house prices along the Herengracht canal in Amsterdam – was created by real estate finance professor Piet Eichholz of Maastricht University. Eichholz was frustrated by the tendency of papers to take a ‘long run’ view of house prices that only went back 20 years or so. He suspected there was a myth which says that real-estate values go up significantly over time, and that this is especially true for central city locations, so he began studying transaction records for the Herengracht area going back to the mid 16th century. More than 300 years of data should be sufficiently ‘long run’, right? His data ended up challenging that myth. Note that the chart here is adjusted for the Dutch retail price index.
This post is not intended to be a discussion of the Herengracht index itself. You can Google it and find that out for yourself. My purpose here is to discuss how people have reacted to the chart when I showed it to them.
The reactions are pretty binary. One group of people apply the this-time-it’s-different principle. This principle says, as its name suggests, that the world has fundamentally changed in some way such that the past will not resemble the future. The mean reversion we see in Herengracht will not be repeated, and real house prices will continue to rise indefinitely.
Of course the principle has been proved wrong in the past. The economist Irving Fisher famously claimed, just prior to the Wall Street Crash of 1929, that the stock market had reached “a permanently high plateau”. This cost him a lot of money, as well as his academic reputation. However that does not refute the principle, which always relates to this time (the early 21st century) not that time (1929).
Sometimes there is a bit of logic to support the principle. I discussed this a lot with economist David Miles while I was at the Bank. David’s theory (as I understand it) is that the world had as it were filled up by the 1950s. City centres began as medieval rabbit warrens with no apparent planning or design. Then as the railways were invented the Victorian suburbs filled up in what we could call the Zone 2-4 world, then with the advent of the motor car in the 1930s, and further expansion of the suburban lines, we reached Zone 6. Then it all necessarily came to a halt. There was no more commutable land left, Zone 7 doesn’t exist, the same process was happening in cities all around the world, and so that is why prices have risen constantly since the 1950s, and will continue to do so because they aren’t making the land any more.
Actually I think that’s a terrible theory, and I will discuss it later. I am simply repeating the sort of protracted discussion that occurred in the Bank before I retired, and may well be continuing now.
Turning to the second group of people, these applied the this-time-it’s-not-different principle, coming to the conclusion that the mean reversion we see in Herengracht would be repeated at some not easily predicted period in the future. This group was not large, and the reason is not difficult to see, being connected with the phenomenon of denial. Research on denial suggests that the it is at is most intense when what we are denying challenges some deeply held and generally comforting belief about reality. Global warming denial is like this. We drive a car, we take long haul flights, we have warm central heating (and heating is actually the main problem), and it is painful to think this might be collectively destroying the world.
So we resort to the comfort of denial. We can sort of see the reality as it were beyond a curtained window out there in the cold, but baby it’s warm inside, so deny the pain for now. Just so with Herengracht. You can see that it’s going to happen, but think what else will happen if it does. Real prices halving in value just to get back to the mean? To a quarter or less of value if we overshoot, as Herengracht has in the past? What happens to the pension wealth locked up in residential property? What happens to the economy? Forget Brexit, that would be as nothing. It’s simply unthinkable, just close the curtains and turn the heating up.
Or perhaps this time it really is different. There is always a first time, as they say.