Controversy over rent cap

What are the current economic debates on housing? A brief overview of the most important points of contention.

 

The overturning of Berlin’s rent cap has caused quite a stir – and a lot of agreement among economists. But what is the alternative? No regulation at all? Or a different kind? Here is a brief overview of the economic debate.

On the one hand, there are those who reject any rent control, citing the efficiency of markets. This argument can be illustrated by the example of the housing market model, which often finds its way into introductory courses in economics as an example of inefficiency of state regulation. In the well-known model of the x-shaped supply and demand lines, a price cap distorts the signalling function of prices by which supply and demand are regulated, leading to welfare losses as supply is artificially scarce, resulting in a shortage of the good. Or as the Swedish economist Assar Lindbeck once put it: “Next to bombing, rent control seems in many cases to be the most efficient technique so far known for destroying cities.”

However, whether the housing market is really a good gateway example of the efficiency of markets and the inefficiency of government regulation is questionable for two reasons. First, housing is not an arbitrary good, but a basic need with far-reaching social implications. Consequently, there are good reasons why an allocation of this good should not be based solely on individual willingness to pay, but should also take other factors into account. Secondly, the housing market is far from the perfect competitive market in the textbook model due to various factors – for example, high transaction costs when moving, long duration of supply adjustment (construction), limitations of supply due to scarce building land and bureaucratic hurdles – which makes the policy recommendation of a deregulated housing market, as derived from the model, appear less clear.

Neither no regulation at all nor too harsh regulation thus seem to be necessarily purposeful. To facilitate the assessment of housing policy measures, the literature on rent controls distinguishes between first and second generation rent controls . While the first generation covers harsher measures that target the entire market, the second generation regulates only parts of the market and can thus be welfare enhancing under certain circumstances. By exempting rents for new properties from regulation and limiting price caps to the existing stock, the signalling function of the price is only disrupted in a weakened form, thus maintaining incentives for new construction. Some studies even show that clever regulations can create incentives to build more, as higher rental income can be expected from uncontrolled new buildings.

A drastic and direct intervention, such as the Berlin rent cap, can rather be assigned to the first generation, which overshoots the mark. The cap has led to a considerable decline in the supply of rental housing. While first-generation interventions are clearly rejected by economists, the discussion about second-generation regulations is controversial. On the one hand, there are those who sharply criticise even weaker interventions in the housing market such as the rent brake and instead recommend a further withdrawal of the state from social housing construction. On the other hand, there are those who are more positive about regulations such as the Mietpreisbremse. What unites both sides is the notion that a sustainable and long-term solution must lie in an expansion of the housing supply – meaning: more construction. Even if the ideas on the concrete form of this diverge again.

The main argument of rent control advocates is to use regulation to cushion undesirable social effects through displacement and redistribution effects from tenants to landlords resulting from shifts in demand effects until the situation has eased through additional creation of new housing. Opponents of regulation argue that price regulations would lead to excess demand and increase scarcity because the allocation mechanism via prices is disrupted. It is true that regulations do not suddenly create affordable housing for all and above all protect those who already have a home. But since housing is not an arbitrary good, the argument that inefficiencies are accepted in order to create a balance between social interests and the necessary investments in new housing could be valid here. This can only succeed if the economic effects of regulation do not (or only to a limited extent) have a negative impact on the creation of new housing. Whether this is the case is ultimately an open empirical question.

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