The UK Housing Market:Measured Decline or Total Collapse?

John Muellbauer and Stephen Nickell

Stated Meeting Seminar

Nuffield College

7th March, 2009

• What has been happening?

House prices, house-building, households, incomes.

• Do all the recent changes matter?

• Prospects:

House prices, house-building plans, households.

• The bigger picture.

• Impact on the overall economy.

What determines house prices?Basically, the “price” of houses is fixed at the level at which the

demand for houses today is equal to the fixed stock available today.

In the recent past, demand has been shifting to the right more rapidly than the stock (which moves to the right by around 3/4% per annum).

Stockt

Pt

Price

Demandt

Houses

So house price inflation depends on how fast demand rises relative to the available stock.

Houses

Pt

Price

Demandt+1

Demandt

Stockt Stockt+1

Pt+1

• Over the short term, house price inflation is dominated by the speed of the demand shift. Over twenty years, however, the rise in the stock is “big enough” to make a significant difference to the overall rise in house prices over this period, and hence to the average rate of house price inflation.

• What are the implications of all this?

• Typically, the price of houses exceeds, often substantially, their replacement costs (ie. the costs of rebuilding). The difference is the value of the land.

• This means that house prices and house price inflation are, currently, more or less unaffected by construction costs. Note, current construction costs impact neither on the demand for houses nor on the existing stock.

• If construction costs go up while house prices remain unchanged, land prices (ie. the price of land with planning permission) will fall.

• The same argument applies to tariffs or an infrastructure levy.

House Price Inflation in the Medium-Term

• Over the medium term, the key to house price inflation is the rate at which demand (the demand side) increases relative to the rate at which the stock increases (the supply side).

The Supply Side• The rate at which the stock increases is determined essentially

by the planning regime and the capacity of the house building sector.

• The more restrictive and directive is the planning regime, the lower the rate at which the housing stock rises and the higher will be the rate of house price inflation.

• Example.

• What about the policy of cutting stamp duty to first time buyers (FTBs)?

• The key point to recognise is that this can only help FTBs if the supply of FTB type houses is higher than it otherwise would be.

• Initially the demand for FTB type houses rises and with constant supply, their price rises by the amount of the tax cut. So the tax cut goes straight to the existing owners of FTB houses.

• This price will bring forth increased supply only if keen landowners/house builders can persuade planners to release more building land. Unlikely. So aside from some, probably tiny, composition effects, no other changes will ensue.

What Determines Demand and Prices?

• Real incomes and the number of households relative to the number of houses determines the trend.

• Note income elasticity of demand > price elasticity. So cet. par., as incomes rise, prices tend to rise faster than incomes.

• Other factors include ease of borrowing, long-term real interest rates. Ease of borrowing has been crucial in the last 18 months.

1997 - 2007• From 1997 to 2006, real house prices more than doubled. Real earnings

increased by around 15%.

• The ratio of (lower quartile) house prices to (lower quartile) earnings rose from around 4 in 2000 to over 7 in 2007.

• From 1996 to 2001, housebuilding was at a rate of around 135K per annum, households increased at around 159K per annum.

• From 2001 to 2006, housebuilding was at a rate of 146K per annum, households increased at around 199K per annum. Incidentally, this rate of housebuilding adds around 1% of England to urban areas every 20-50 years depending on use of brownfield/density.

• Households are now rising at over 210K. Net migration represents around one third. Increasing life expectancy and behavioural changes continue to lower household size.

Indexes of real house prices, earnings and GDP, United Kingdom (1997 to 2006)

0

50

100

150

200

250

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Inde

x (1

997=

100)

Real GDP

Real House prices

Real Earnings

Housing affordability: ratio of lower quartile house prices to earnings

0

1

2

3

4

5

6

7

8

9

10

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Rat

io

LONDON

SOUTH EAST

SOUTH WEST

EAST

ENGLAND

WEST MIDLANDS

EAST MIDLANDS

YORKSHIRE AND THE HUMBER

NORTH WEST

NORTH EAST

Housebuilding: permanent dwellings completed, by tenure, England

0

50000

100000

150000

200000

250000

300000

350000

400000

1946 1952 1958 1964 1970 1976 1982 1988 1994 2000 2006Num

ber o

f com

plete

d dw

ellin

gs

Private enterprise

RSLs

Local Authorities

All dwellings

Household estimates and household projections, by household type, England only

0

5000

10000

15000

20000

25000

30000

1981 1986 1991 1996 2001 2006 2011 2016 2021 2026

Num

ber

of h

ouse

hold

s (0

00s)

one person

other multi-person

lone parent

cohabiting couple

married couple

The Credit Crunch

• The inability of UK mortgage lenders to tap the still buoyant supply of world savings has generated severe mortgage rationing to first time buyers.

• So, rapid decline in house prices.

• Squeeze on housebuilders, collapse in housing investment.

• Private rental sector cannot take over.

Does it Matter?• As affordability and housing shortage worsens, more people are pushed into

private renting, forcing up rents.

• More people are driven into the already hard-pressed social renting sector and queues lengthen.

• Deprivation increases and the situation worsens in already deprived areas.

• This affects us all. The economy suffers from the consequent impediments to labour mobility.

• Key workers are unable to find somewhere to live near where they work.

• Increasing quantities of taxpayers money are required to address these problems.

• Housing wealth has risen enormously. Can the country really be wealthier because we collectively restrict the supply of building land?

Number on housing register

0

500000

1000000

1500000

2000000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Number on housing register

What do Affordability Prospects Look Like? І

• Household projections suggest that the number of households in England will grow by an average of around 223K per annum over the next 20 years. This rate is significantly higher than in the recent past. Furthermore, projected growth up to 2020 is even faster at an average of around 230K per annum.

• 168K new homes were completed in 2006-7, fewer subsequently.

• The fact that the rate of completion of new homes has been well below the rate of formation of new households means there is a large build-up of unsatisfied demand.

• The evidence suggests that over the long-term, a 1 per cent rise in real incomes raises house prices by 2 per cent if the housing stock remains unchanged.

What do Affordability Prospects Look Like? П

• Suppose credit conditions return to normality.

• If the housebuilding plans currently embodied in the draft RSS plans (around 200K p.a.) are fulfilled, house price to earnings ratios are likely to rise from around 7 to around 10 over the next twenty years.

• If Green Paper plans (reaching 240K p.a. by 2016, 3m. new homes by 2020) are fulfilled, house price to earnings ratios are likely to rise to around 9.5 over the next twenty years. This may be reduced significantly by biasing new homes towards more expensive regions and even further by some bias towards larger family homes which are in shortest supply.

• NHPAU projections indicate that a plan to reach 270K new homes p.a. by 2016 would come close to stabilising affordability in the long run.

What do Affordability Prospects Look Like? III

• These are long-run scenarios. So does the current slowdown make any difference?

• Not much in the long-term unless elements of mortgage rationing become permanent. There will be a temporary slowdown because of severe mortgage rationing. But as this eases, the forces of rising incomes and growth in the number of households will start driving up house prices again, especially if housebuilding remains modest.

Overall Prospects

• Housing will be more “affordable” if there is permanent mortgage rationing.

• People will not, however, be better housed.

• Instead of high prices locking people out of the housing market, the mortgage lenders do it instead. No real improvement.

Mortgage rationing would reduce prices, but the level of supply will still impact on affordability outcomes…

For illustrative purposes only

3 .0 0

4 .0 0

5 .0 0

6 .0 0

7 .0 0

8 .0 0

9 .0 0

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

RSS supply, rationing to 2012 RSS supply, rationing to 2031

NHPAU top end, rationing to 2012 NHPAU top end, rationing to 2031

LQ A

ffor

dabi

lity

Rat

io

UK house prices in the global context

• Cameron, Muellbauer, Murphy (2006) – basis for CLG’s housing affordability model→

• if goldilocks economy of 2006-2007H1 had continued, UK house prices were only approx 10% overvalued at mid-2007.

• But goldilocks economy has collapsed, both at global and national levels.

• What are global prospects?

Origins of Global Financial Crisis (1)

• Failure of prudential regulation by Fed, BOE/FSA and ‘pro-cyclicality’ of Basel II.

• Over-leveraged shadow banking system arose partly to by-pass regulation.

• E.g. in 2004 SEC (Securities and Exchange Commission) caved in to investment bank lobbying (e.g. GS, Lehman) to reduce capital requirements on investment banks.

Why?(2)

• Competitive advantage e.g. in securitization put pressure on retail banks (e.g. Citi, Bank of America, Wachovia) to use off-balance sheet vehicles to by-pass capital adequacy rules.

• Distorted reward structure of originators of financial products and of rating agencies.

• Herd behaviour of bankers.

• Poor modelling of risk, esp’y macro risk – short history based on ‘the Great Moderation’ period.

• E.g. S&P decided in 2000: piggy-back mortgages were no more risky!

(3) Examples: SIVs and CDS

• ‛Special investment vehicles’ were supposedly off-balance sheet investments by banks, often very risky and not transparent.

• As crisis unfolded, had to be largely brought back onto bank balance sheets.

• ‘Credit default swaps’ traded between banks and other financial institutions – not on open markets and not transparent.

• Original insurance purpose - but in practice financial instruments of mass destruction since they amplified counter-party risk.

“We structured the deal so it won’t make any sense to you.”

Source: The New Yorker

Why? (4)

• Globalisation made it possible to spread bad risks round the globe.

• After the Asian Crisis of 1997-8, the Asian economies built up huge foreign exchange reserves. Their excess saving kept interest rates low for Western economies, fuelling credit and asset bubbles.

• Bush administration keen to extend home ownership - via private debt - to the poor.

Why? (5)

• US tax regime stimulates desire for debt – unlimited tax relief for mortgages.

• Fannie Mae, Freddie Mac, Fed Home Loans system with implicit govt. backing created illusion of low risk options for US borrowers.

• Walk away option from negative equity in US encouraged risk-taking by households.

• Monetary policy errors in 2002-5: low rates led to desperate search for yield – risky assets!

Why ?(6)

• Oil and commodity price spikes driven by high resource-use Asian and other emerging market growth spurt in 2006-7.

• Exacerbated by hedge fund and other speculation.

• Raised inflation and eventually cut real income growth in industrial economies.

Why? (7)

• Recent policy errors compounded crisis:

• Lehman Bros default.

• Failure by central banks in Europe to respond to crisis in October and support well co-ordinated treasuries. See ‘The folly of the central banks of Europe’

• http://www.voxeu.org/index.php?q=node/2488

• Initially wrong US bank rescue plan (TARP).

Household credit channel

• Central to understanding prospects in ‘Anglo-Saxon’ economies and how other economies differ.

• Shift in credit supply function e.g. ‘credit crunch’ has profound effects not just on level of house prices and consumption but on how monetary policy works.

• One channel in following chart:

Lower Demandfor Housing

SlowerGDP Growth

↓Home Prices & Wealth, SlowerConsumption

Mortgage andHousing Crisis

Less HomeConstruction

Lower Capital ofFinancial Firms

↑ Counter-PartyRisk, Money &Bond Mkts Hit

Credit StandardsTightened

on All Loans

Global Prospects

• All parts of global economy are now in Keynesian-style demand-deficient recession.

• Fiscal and monetary policy solutions are well-known when inflation is dead.

• Belated ECB interest rate and fiscal loosening to come.

• Stuttering recapitalisation of the banking system is in train, plus ‘son of TARP’.

Prospects cont’d

• Eurozone policy failures have continued.

• In Nov-Dec. ECB cut interest rates less than fall in expected inflation. In Feb. kept rate unchanged, so raising real rate.

• German fiscal policy late to grasp coming tidal wave on Germany – hoped to free-ride on overstretched US fiscal stimulus.

Blockages to sane policy

• 1. Endemic conceptual/model failure was to omit household credit channel/financial accelerator from CB models.

Blockages to unorthodox monetary policyor ‘quantitative easing’:

• 2. Old monetarist fear that “‘printing money’ is inflationary” even after huge wealth destruction and excess capacity.

• 3. “‘QE’ is only possible once the policy rate is close to zero”.

• 4. Fiscal-monetary co-ordination need for QE.

Prospects cont’d

• Current problem is fear – as in 1933 in FDR inaugural.

• Great Depression and Japan-style ‘lost decade’ could be prevented by sane policy.

• One big difference: fall in oil and commodity prices is very good for Western households.

• Indebted US and esp’y UK households helped by lower interest rates – unlike liquid Japanese.

Long term

• China and other ‘emergers’ will need new, lower, domestically oriented growth strategy.

• Partial de-globalisation with reduced financial imbalances.

• Smaller financial services industry, lower levels of leverage, tighter regulation.

• Suggests house price/income ratio will revert to lower trend.

UK in longer term

• Reduction in size of financial services industry is negative supply shock.

• Saving rate has to be higher than in last decade.

• Government debt will constrain PDI growth.

• Lower value of £ is helping rebalance economy but takes time.

• Also helps top end of housing market hurt by collapse of City jobs and bonuses.

Evidence from Cameron-Muellbauer-Murphy CEPR DP 2006• Regional hp model based on inverse, solved out housing

demand function.

• Given housing stock, long-run income elasticity of real hp is 1.6, but income growth important in short run, shifts with Credit Conditions Index.

• CCI level effect on long-run real hp.

• Interaction with nominal and real interest rate – credit crunch makes nominal rate matter more, real less.

Hp evidence cont’d

• Strong momentum and downside risk effect: last year’s appreciation translates into 0.4 for this year’s, but negative return in last 3 years is negative for prices. Explains over-shooting.

• Ripple effect from London, and London and SE sensitive to stock market. Hence UK hp sensitive to health of financial services.

• Model attributed most of rise in real hp since 1997 to income and pop growth relative to stagnant housing stock; some to shift in credit availability and low interest rates.

• Speed of adjustment has fallen because of Stamp Duty rise – from 0.35 to 0.2 p.a.

• Slow and volatile adj. to long-run equilibrium: all factors except supply side and interest rate now more negative than last year: real income down; credit supply down; momentum effect reversed; down-side risk ; net migration ; stock market.

Back of the envelope calculations:-

• Overvaluation in mid-2007, say -10%

• Lower income growth, -6% or worse.

• Reduction in long run credit, -5%.

• Lower interest rates, say +2% but could be better.

• Short run dynamics (credit, momentum, downside risk, income etc.), say -7% or worse.

• Slow speed of adjustment means that hp could be away from long-run equilibrium for long periods.

• Net effect -26% but could well be worse.

• Much depends on global outcomes.