Rory Sutherland

The engagement-ring theory of property bubbles

We buy houses like we buy diamonds. That’s why they’re so stupidly expensive

• From magazine issue: 29 March 2014

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Alexander Larman

What happened to the Rishi Sunak I knew at school?

Let’s consider one decidedly weird market: diamonds. In order for a chap to show the seriousness of his intentions, he has to demonstrate some costly form of up-front commitment to his fiancée: he therefore spends a large amount of money on an allotrope of carbon for her to wear on her hand.

Diamonds are what’s called a Veblen good. Their value lies in their being widely known to be expensive. And much of this value was created out of thin air by an advertising campaign, ‘A diamond is forever’, written by Frances Gerety (part-inspiration for Peggy Olson in the series Mad Men) at the agency N.W. Ayer. One of the greatest slogans of the campaign simply read: ‘How else can a month’s salary last a lifetime?’

That is pretty damned clever/evil. A social norm is created that you are deficient husband material if you don’t spend a set proportion of your annual salary on carbon-based jewellery. The buyer therefore asks not ‘What do I need?’ but ‘I need to spend $X,000 — now what can I get?’ We don’t generally do this when we order a pizza. As I have become richer, my pizzas have probably become a bit more elaborate — but I don’t buy pizza based on a fixed proportion of my monthly salary. That would be silly.

But there is one area where behaviour is stranger still: when people buy a house. I would guess the majority of people adopt the following approach. 1) Go to bank. 2) Ask how much they can borrow. 3) Work out what they can spend in total. 4) Buy a house that costs that much.

If someone wrote a slogan for the property market, it would be ‘How else can a lifetime’s salary buy me an extra bedroom?’

Why do we do this? I don’t know. It’s a herding effect, I suppose. But the behaviour creates very dangerous consequences. First of all, it means that the price of property will not reflect any underlying use value — it will simply be a function of how cheap and easy it is to borrow money.

But it also creates a bonanza for banks. Normally there is a limit to what banks can lend — since people have natural limits to their urge to borrow. Few people go to a car dealership and ask ‘What’s the most expensive car I can afford?’ But in the property market, normal limits to borrowing don’t seem to apply. Hence the Ponzi scheme we see now.

So if property prices are too high, the fault does not lie only with the Russians and Chinese. In some peculiar psychological way it lies with ourselves. Germans, who have what I call a ‘Protestant Consumption Ethic’, don’t seem to exhibit the same behaviour.