After years of frantic exuberance the British housing market is stalling. Housing transactions have collapsed, prices are falling and a major mortgage lender was nationalised – an unthinkable event a year ago. Economists are now fretting that the housing slowdown will hit the economy hard: the building sector will slow, people will feel less wealthy and be less able to borrow cheaply against their houses to fund spending. This work-in-progress paper sets out some of the processes underlying the housing market and suggests some of the effects it might have on the wider economy.
A few themes:
Dinner party tittle-tattle about house prices is still stuck at the anecdotal; and plenty of coverage remains at the level of dinner-party tittle-tattle. Some people focus on planning controls, some on immigration, others on financial stability. I want to be more rigorous, taking the explanation one step at a time starting from bricks and mortar and ending with how the structure of the world economy has stoked a housing boom in London.
Supply and demand is a simple starting point for understanding house prices – what do people want, and what is available? If there’s a shortage of houses and it’s hard to build any more, prices will rise. But the other side of the market is the supply of money. As we have seen recently, if people can’t get mortgages then prices won’t rise, no matter how strong the demand and how low the supply. You have to look at the two things together to understand what is going on.
The imbalance between the supply and demand of housing in the UK has been widely noted – there aren’t enough houses for everyone who wants one. Demand has increased from immigration and changing patterns of living, with more single-person households. At the same time supply has been restricted – the planning process is slow and there are tight restrictions on building. The green belt is only the most prominent of many special designations that protect land from development, with the result that people are forced into relatively cramped and expensive accommodation. The government has pressured developers to build in existing urban areas at higher densities, which does not reflect people’s aspirations for the space and land provided in suburbs. But this alone cannot account for the boom in house prices.
A lot of people think ‘speculation’ is to blame. From this angle, buy-to-let investors have hoovered up the housing supply, bidding prices up further and further in a manic bonanza of greed. Speculation is an implicitly moral category, suggesting profiteering without social purpose. And there is some truth to that. On the other hand, speculation makes for more efficient markets with lower transaction costs, so condemnation of speculation as wasteful should be tempered. But to understand what is going on we need to probe more deeply, rather than putting it down to the herd behaviour of middle class wannabe Rachmans.
Few people buy houses out of spare cash. Not many have the cash and that’s why most take out mortgages that spread the cost over decades. The cost and availability of mortgages is therefore crucial in determining house prices. One way to think about it is to consider the cost of a mortgage compared to the cost of renting. If it costs, say, £500 a month to rent a flat, and you could buy the flat with a 100%, 25-year mortgage that costs £600 a month in repayment, you’ll probably keep renting. But if interest rates fall and the mortgage costs £400 a month, you’ll buy. And more people will keep buying, and pushing up prices, if mortgage costs keep falling. On the other hand, if mortgage costs rise sharply, house prices will fall because people won’t be able to afford to buy any more. I’ll explain this in more detail in an appendix at the end, but for now let’s keep the argument moving along.
People who talk about speculation often offer a truncated explanation, because they stop at the speculator buying houses. They think that wealthy middle class people are pumping their savings into houses because they’re disillusioned by the stock market or they’re seduced by the promise of easy riches in housing. This neglects something that should be obvious – these investors need mortgages, and without cheap and plentiful buy-to-let mortgage finance they would still be stashing money away in Post Office saving accounts and mutual funds. In fact this is the most intriguing part of the analysis, because it brings in the financial markets and the rest of the world economy. Underlying the house price boom in London are millions and millions of savers in China and other emerging economies. Let me explain how this works. I’ve taken China as an example, but what follows applies across a number of cash-rich emerging economies.
As China’s economy has grown it has generated increasing amounts of money from exports. A lot of that has been invested in manufacturing industry and infrastructure. Some has funded increased consumption. But a lot has been saved; consumption remains relatively low. The effect of lots of savings in an economy is that interest rates will be kept low, because interest rates reflect a kind of bidding process between borrowers, who have to offer a certain rate of interest to persuade people to lend to them, and lenders (or depositors) who have to be enticed to save money by offering a given interest rate. Banks stand in the middle of this process. Because interest rates have been very low, China has invested heavily in capital. But there are diminishing returns to building more and more factories. So there is still a surplus amount of capital. This ‘spare’ money has been used to buy enormous quantities of overseas assets, especially US government bonds.
Overseas purchases of US government bonds have the same effect as lots of savings domestically. The effect is to push down interest rates and makes more money available to lend, because the government’s borrowing requirement is being fulfilled by foreign investors without the need to scoop up money domestically. Thus the supply and demand dynamics shifted; instead of it being hard to borrow money, it became cheap and easy. It was in that context that the infamous mortgage-backed securities took off. Banks sold off mortgages to willing investors, which meant that the banks were also free to lend much more money at lower rates, which pushed up house prices. The ‘credit crunch’ has seen the partial reversal of that process. Financial people have realised that although money is plentiful, there is still a real risk that it will never be paid back. So it has now become much harder to get a mortgage, thereby reversing some of the processes that drove the house price boom.
There are still some important factors militating against a house price ‘crash’. Interest rates remain relatively stable and low. Unemployment is still low. And there is still high demand for an inadequate stock of housing. But when we think about how prices are likely to change, we need to bear in mind the financial environment as well as looking at bricks and mortar.
What’s the point of building houses if you can’t sell them? Despite elevated prices, far in excess of building costs (most of the value is the land), the lack of mortgage finance means that there’s little incentive to build houses. Planned developments are being mothballed and housebuilders are sitting on their land banks. Even in the context of a crying need for more houses, the financial mess we’re in means that houses aren’t getting built. A neglected by-product of the recent dislocation in the housing market is that house prices are falling while rents are rising, because people are still competing for a limited supply of housing.
The corollary of this is that the discussion of housing is distorted. A recent article in the Financial Times crowed that those who thought there was a shortage of houses have been shown up as fools because house prices are falling. That’s plain wrong. Housing is still needed, and supply is still being constrained by barbarous planning restrictions. We can understand this better once we recognise the role of finance as well as the role of supply and demand in establishing house prices.
It will certainly now be harder to promote transformative development projects and to articulate a vision for transforming London when people are preoccupied by housing malaise. But we should be clear that changes in the price tags of houses do not mean that we need fewer houses.
The financial fallout from the credit crunch is profound. Whole businesses have ballooned in recent years, sucking in talented people to structure, model and sell mortgage backed securities. Now they have popped. It will affect the profitability of City institutions, the bonuses that have buoyed the housing market, and the high levels of employment that have pushed up salaries and drawn in immigrants. For many, this is only hubris reaping its just reward. But step back from the ethical arguments and let’s dispassionately consider the results: London remains a great financial centre – by some measures, perhaps the greatest; but its reputation for regulator excellence is dented, some business lines are closing down and frenetic recent growth has stalled.
The great mass of activity in the City is more prosaic than its image. Underlying the ethereal financial economy is the mass of businesses that need loans and foreign exchange, and which need to manage the risk of interest rate changes and price volatility. A lot of people take pleasure seeing banks suffer; and the securitisation market’s fall has been dramatic. It’s a bad time to be a bank shareholder, but it won’t be the end of the City. Finance will continue to provide employment and generate wealth for London.
London faces a triple-whammy. The financial sector, which has driven London’s growth, is stalling. House building and construction, partly driven by demand from the booming financial sector, looks precarious. And the decline in the British economy relative to Eastern Europe and Australia means that the inflow of migrants is reversing. Inflation is rising, growth is slowing, house prices are falling, and the government’s deficit is rising. The economic news is mostly bad.
It all adds fuel to a fatalistic disdain for transformational projects. But there is still frustrated demand for housing that could be met with imagination and political will.
Michael Savage is in banking
In the 1970s and 1980s interest rates and inflation were both high – and volatile. That meant that initial repayments on a mortgage were very high, although they would seem less later on because salaries rose with inflation. This acted relatively to constrain house prices. For example, if interest rates are at 10% and your net salary is £20,000 then a mortgage of £100,000 would take half your income on interest alone. On the other hand, if inflation is 8% and your salary increases by inflation plus 2% then within five years your income will rise to £32,200 and mortgage repayment will be 31% of income.
If interest rates are at 5% and inflation is 3%, on the other hand, if you are willing to pay half your salary on your mortgage, then you can afford to borrow £200,000. But if your salary increases at inflation plus 2% then in five years you’ll only be earning £25,500 and repayments will be 39% of income.
People buying houses tend to consider the immediate impact on their finances, which makes sense when comparing buying costs with renting costs. As a result changes in interest rates make quite a big difference to the cost of housing. Where supply is plentiful, prices still tend to rise if rates fall, because people can buy bigger and better houses, and prime locations are inherently scarce (there’s a limit to how much you can build in Mayfair no matter how high prices go, or how far planning restrictions are relaxed).
© 2009
How much growth constitutes ‘growth’ in the closed circles of urban regeneration? How big are the big ideas?
Ian Abley
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