Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 15 August 2013

The wrong sort of recovery

First, I want to admit to a failure of imagination. Although I described this post as perhaps one of my better forecasts, I did get one important detail wrong. I said (in May 2012) that if there was a risk that UK growth would not come good by 2015, the Chancellor would apply additional stimulus measures, and I suggested investment incentives for firms as an example. That was a dumb example. I suggested it because I thought it made macroeconomic sense. Yet it was dumb because I also knew by then that this was not the way George Osborne thinks. I should instead have asked myself what stimulus measure would provide the best political advantage. And the obvious answer is to make it easier for people to buy houses, because this pushes up house prices. Now, as an economist, you might think rising house prices is the last thing we need, with UK house price to earnings ratios still very high (see below). But from a political point of view, if you are trying to get homeowners’ votes, it makes a lot of sense to engineer a short term increase in house prices, particularly if you make it immediately easier for those who want to buy to get ‘onto the ladder’.

So that is what the Chancellor did, with his ‘Help to Buy’ scheme, which either provides guarantees for a significant proportion of 95% mortgages, or provided top-up loans for up to 20% of the house price. Frances Coppola is shocked. She writes

“As my regular readers know, I am determinedly politically non-aligned, so what I am going to say now will probably shock a lot of people. Osborne's behaviour both angers and frightens me. He is playing brinkmanship with the UK economy to achieve political ends. Nothing he does makes much sense from an economic point of view - which is why the flagship Help to Buy scheme has been universally panned, even by his own department and by people from his own party. But if you view his actions as entirely determined by his desire to secure a Conservative victory in 2015, it all makes perfect sense. He is dangerous.”

As my regular readers will know, I’m afraid I very much agree. In my ‘final verdict’ on the Chancellor, I wrote “He is a political tactician, who time and again has put party political gain ahead of the economic interests of the economy.” (That should have been ‘of the country’, but you know what I meant.)

However, as I always like to try to think well of this government’s macroeconomic policy, let me put the argument that getting a recovery by making it easier to borrow money to buy houses makes some sense. It goes something like this. An important reason why the recovery so far has been anaemic is that UK banks are broken. So they are being far too cautious in lending for house purchase. In particular, they are worried that house prices could well fall, and they do not want to pick up the tab if this happens. If you think that is a distortion (because you think they are being too risk averse), then Help to Buy just corrects that distortion. In addition, there are good reasons why one of the byproducts of this scheme might be a boost to aggregate demand.

What is wrong with this argument? While the idea that UK banks are being excessively risk averse in their lending to small businesses is quite plausible, the argument applied to housing is not. The chart below is Nationwide’s first time buyer house price to mean gross earnings ratio.

It has fallen as a result of the recession, but remains historically very high. There are two obvious reasons why it is so high: an inability over the last decade or two to increase housing supply in line with demand, and the fact that interest rates are currently very low. It is a clear objective of government policy to remove barriers to increasing supply, and at some point in the not too distant future interest rates are likely to rise. There is therefore a significant chance that in the medium term real house prices will fall. So it is quite reasonable that banks want to transfer that risk on to someone else.

Now you could say why shouldn’t that someone else be the government? What does it matter if at some point in the future taxes are raised or spending cut to pay for the losses the government will incur on these schemes. If it gets us a recovery, that is a cost worth paying. And that is half right. After all, fiscal stimulus involves spending now, but paying for that with higher taxes or lower spending later. Yet this comparison shows how wrong this scheme is. If we borrow now to increase public investment, then when taxes are higher in the future to pay back that borrowing we have something to show for it. If taxes go up in the future to cover the defaults on loans made to house buyers, we have nothing.

So I think Frances is exactly right. The Chancellor is a very skilled political operator, and with schemes like this the UK is in danger of enjoying another five years of bad economic decisions designed to gain party political advantage.



  1. Another explanation for Osborn’s bizarre economic policies is deficit-phobia: a widespread ailment that has infected the IMF, OECD, etc etc and does almost as much damage as bubonic plague in the 14th century. I.e. there is an aversion to straight increases in government spending, or encouraging private spending via tax cuts because that increases the dreaded deficit. So as an alternative, Osborne & Co go to EXTREME lengths to encourage private sector lending and borrowing. And that leads to the absurdity that is QE (making the rich richer). Plus it leads to “Help to Buy” which subsidises the purchase of houses up to £600,000: well over twice the price of the average UK house.

  2. Completely agree this laughable policy is all about the next General Election and to hell with the economy beyond that. Don't forget, the first-time buyer lured into the market by the Government is going to suffer as well as the tax-payer when prices fall; will we be seeing complaints of mis-selling?

    Michael Portillo keeps pointing out, on Andrew Neil's excellent _This Week_ drinking game, that the Tories need gains larger than any UK Government has had in recent times. Not getting the electoral boundary changes pushed through has moved it out of their grasp.

  3. When most newspapers and the business lobby groups supported the Tories before the 2010 election, given the culture of never apologising, it gave the Tories an awful lot of, if not support, then room for manoeuvre to be met with (embarrassed?) silence. They are all in it together.

    I am reminded of Ross McKibbin's passage:

    "When speaking of the state and its relation to society, Thatcherites use the word ‘freedom’, rarely ‘liberty’; and for them, freedom means freedom within a market politically constructed to favour some against others. They do not often use the word ‘liberty’ because it has different political connotations. Thatcher is a conservative and conservatives are not libertarians. The market for them has a disciplinary function, as does the state. Which of the two a government uses for a given disciplinary purpose depends on circumstances, but either will do."

    The Thatcherites never thought that housing bubbles would be necessary to keep their political credo going in, say, 1980, but evidence does seem to be of the contrary, and they are trapped willingly into Robert Shiller's 'Bubbles Forever' (Jul. 17, 2013).

  4. Tell us something we don't know. The Tories have always been thus. In both short and long term, their policies have made the rich richer and the poor poorer. The one thing that we had, at one time, were strong trade unions. Alas Thatcher put an end to that. We no longer have secure jobs, pensions and house prices are out of all proportion. Negative equity on houses was what started many of the problems that we have today. This looks like it is just around the corner again (5 - 10 years).
    It would be nice if we had politicians who genuinly believed in doing what is best for the country and not just to save their assets (substitute whichever word you like). In short, nothing new then !

  5. Not agree with most of it.
    What Osborne is doing is very similar to what the FED has been doing with especially QE3.
    QE3 makes buying a house cheaper and has mainly 2 advantages. Reverses partly the collpase in prices and subsequently mortgage loans which caused the crisis.
    Second the wealtheffect. Give people the impression of a good running economy and they start to spend.

    Some remarks:
    1. Housing looks both in the US as in the UK a much more effective stimulus measure than the stndard QE. Standard QE seems to end up with the top 1% (very bad consumers and often financial investors, not in the real stuff that provides jobs) and very little is dripping down.
    Housing serves a much larger group and more ends up in real stuff (consumption and building).

    2. Housing market in most Western Countries is and certainly was bubbling but a crisis is the worst time to get the air out. Like the Dutch example shows. A huge drop in housing prices would have made the crisis much worse for the UK. Nearly all European countries have >50% homeownership combined with very much debt. You bring a lot of people underwater and very likely consumption will go south as well.

    3. Of course this is political. And hopefully it is tried to avoid to let prices rise very much.
    Not a natural combination by far but the air should preferably go out in when the economy soars.

    4. I donot see much difference as said with especially QE3. Seen CBs as part of the government (but independent) and therefor effectively owned by the taxpayer/voters. It can charge for its monetary function which is therefor not much different than a tax.
    By letting advantages slip like in QE3 (suppressing interest) CB let part of their potential revenue slip. In that way it is hardly different from what Osborne is doing only by another part of the government.
    In that respect Simon looks a bit inconsistent as for stimulus he likes to route that via the way Osborne is doing but for this something that is basically very similar it apparently is better to do it the other way around.

  6. 2: so when is the right time to let the bubble deflate? During the next boom? What is going to fuel this boom when debt is already at historic high levels? Pile on more debt to keep the economy going?
    It's not that I know a better solution, but it seems to me all the policies you mentioned are just a desperate attempt to keep things going. And I must admit, you can get away with it for a very long time, just look at Japan.

    1. It is important not let bubbles (and all other unbalances develop) in the first place.
      If you look at Western economies they all have truck loads of unbalances which make using both monetary and fiscal measures very difficult. Probably the best example is the interestrate. Low because of economic downturn but at the same time kicking the bottom out of all especially funded pensionschemes. What you win on one front you might lose on another. Another example is the housing market effectively as Simon indicates prices are very high. However if you let the air out people get underwater and banks likely take a hit. With as a consequence low consumer confidence and no banklending.

      As far as the housing market goes imho you should look how big the bubble is. In the UK it looks possible to inflate the problem away. In other countries better a more structural approach. It is no use having 20-30% of your population underwater for a decade or more. At best you have a lost decade at worst you will be running backwards.
      So for Japan I would say cleaning up the mess relatively early would have been the preferred method. It is a bit contra Japanese culture, next to the fact that politics like kicking the can. So was unlikely to happen.
      In the UK as it basically went low interest with a decent level of inflation effectively did the job.

      Holland took the other road and created a new bubble by putting the priced in tax deduction under discussion. And now the bottom has fallen out of the RE market there. If I am correct 15% of GDP is the underwater part of mortgages now and with around 30% of the homeowners (and all that in 5 years). You never get that straigthened out with a stimulus.

      As said it is not a likely combination, but letting the air out when there is a boom (in prices not necessarily in the economy as a whole although these two are heavily correlated of course). would be my preferred strategy.
      With as remarks:
      -likely hard to sell politically;
      -as a general measure (you remark that there is probably no financial room for let the economy boom at the moment which is another issue);
      -when the gap is not too big as it eg was in Japan or in Ireland and Spain, otherwise it simply takes too long.

      The latter having as an added problem if not attacked early that the bankingsector will be very sick for that time as well as Japan did show. So next to consumer spending being down by a lot of people being under water and the ones not under water scared that they might be, also lending as a problem. As said in countries like Japan it requires too much time to inflate/grow out of the problem and other measure would be required.

    2. Part2
      In a more general sense I would not attack unbalances that are not disturbing things at the moment. There is already an overload of problems you donot need more of them. Imho better attack those when this mess is solved.
      The EU made pensionrules as such a good thing however makes now a lot of pensions underfunded. Which is as such a problem. But you can make that problem even bigger to start a long term national discussion on it. Like they did in Holland. If you have people especially aging ones worry about their pensions your consumer confidence is out of the window.
      Btw it doesnot mean other EZ/EU (and US) have not similar problems but that bubble is still intact and might burst any moment.
      But the Dutch example shows that the combination of no stimulus, bursting housing bubble and bursting pensionbubble is simply way too big to handle. Even in a relatively healthy compared to say France and certainly the 'South' economies. And there are still a few other bubbles that have not got to the surface even in Holland. In Holland you cannot get the pensiondiscussion under the carpet again (like it still is in many other countries including the UK btw).

      So as far as the UK RRE goes I would say inflate the problem away (with hopefully lateron some help from growth, but I am doubtful on that). Take care the air that is still in it not gets out, but certainly not put new hot air in (as Osborne could be doing).
      Which still leaves the regional issue to solve. Macro the market as a whole might looks ok. But in the UK that likely means that the SEast is bubbling up and the rest is still crap. Hard to see a solution for that btw, but a problem and a large one nevertheless.

    3. Right, so basically your advice is that we shouldn't start from here. Thanks. That's really helpful.

  7. This plan of theirs almost looks like crony capitalism. Privatised gains for financiers, socialised losses if it turns into another 2008-style train wreck. And the really sneaky thing of it is that under this scheme, even though the Government is essentially promising to bail out lenders if the market crashes again, none of the financial risk the Government takes on will show up anywhere in the budget.

  8. I think that there is a fallacy here and some bad reasoning. First, rise in "first time buyer house price to mean gross earnings ratio" is simply a reflection of the phenomenon of affordability. House buyers, especially first time buyers, don't assess the price of a house. They don't have the skill to do so. realtor do, but they have an interest in selling houses, so they keep quiet about whether prices are too high or too low. They just want their 6% of whatever the price is.

    Instead, buyers take on whatever loan they can meet the monthly payments on, and in times of low interest rates, that will be a bigger loan than in times of high interest rates, leading to upward pressure on house prices. It's not some sinister plan hatched in #11, it's just how the market works.

    And if #11 decides to help first time buyers onto the house ownership conveyer belt, that's not a sinister plot either, because its actually beneficial to society - which I will pretend "exists". It's beneficial because when young couples buy a house and pay off the mortgage before they retire, their living costs in retirement fall, which translates into lower social support level. House buying, then, can be seen as just a structured savings scheme.

    Is the whole thing problem-free? Of course not, because there will be fluctuations in house prices, some people will default, some people will complain that they are under water, and on and on, and we will love every minute of it because we are so addicted to our economic melodrama.

    And are house prices driven by an inability to balance supply and demand? Possibly so, but if they are, all it says if is that the market is being rigged. If higher prices flowed through to builders, and builders could get permission to build more houses, supply and demand would meet. But that won't happen as long as local authorities treat granting permission to develop housing as some weird power trip.

    All in all, I would say Osborne is probably singing in his bath at the thought of being accused - accused, mind you - of doing something the voters want and which will benefit young couples.

    "Will they vote for me?" he will wonder "And would they vote for Labour if they did exactly the same thing?"

  9. On house prices and affordability.

    It looks clear that houseprices are largely determined by affordability and as such interestrates.

    Leaving very long term trends aside.
    Interestrates have been structurally going down the last few decades. Also in people's perception on how they will develop for the future.
    This has a number of consequences:
    -This has increased the max lending capacity (even leaving income growth aside) and subsequently the price of houses.
    Part of the chart can probably be explained by this. And that part will not constitute a major problem imho. Providing of course you donot reverse the process and move to higher rates again.

    -Very difficult to reverse this process (stabilising and reducing interest rates partly via stabilising and reducing inflation). It simply would mean kicking the bottom out of your RE market (and not only residental). And subsequently under your bankingsector as these would be sitting with huge amounts of bad loans. Plus a big problem for your government finances as there the same problem plays as with houseowners if the interestburden rises.
    The latter meaning that inflationfighting with interest increases becomes a big problem if this would require higher than historical rates. Solve one problem and create another as with so many things in this crisis, simply because of the unbalances galore most Western countries are in.

  10. This scheme as a stimulus measure like much of Ba's stimulus simply sucks.
    Politically it will be very difficult to reverse it even if the economy booms. The dosage is also very difficult to manage as there might be devergence between RE market and economy.
    But like with Ba's social programms disguished as stimulus a politically well working scheme is to be preferred over an economically good working one. Even if results are economically much worse.

  11. Given that excessive house prices have caused the last two major recessions you would have thought that macro-economists might have started advising politicians by now on how to run a policy of stable house prices that avoids boom and bust. Sadly no such luck.

    Osborne has adopted this approach in large part because he is ideologically opposed to all forms of social housing and government spending. If you wanted to get house prices down and the economy moving, then building council houses and paying for them with a hypothecated Mansion Tax would be the way to do it. Osborne opposes both strands of such a policy even though it is debt-free. I would also add that controlling mortgage supply would need to be an integral component of any such policy.

    As for leaving it to the free-market, it won't work because house-builders are addicted to high prices and thus high profits. Why would you build 10 houses for £100k each and £10k profit per house when you can build two houses for £250k and £70k profit each. Construction ground to a halt in the recession, not just because of a lack of buyers or mortgages, but also because building companies sat on partially completed projects and waited for prices to recover. They were able to do this because there was no cost to holding empty property and unlike the car industry, their labour was casual, and so there was no imperative to continue supplying output and looking for income even when the market was falling.

    A market will always be dis-functional if the holder of a commodity (like property) can sit on that asset indefinitely without any loss of value. Markets only clear when the seller knows that their product or asset will lose value with time. That forces the seller to discount the price in order to find a buyer. That is one reason why general equilibrium theory does not work and why interventionist policies are essential for advanced economies to function smoothly.

  12. Excellent article. I wonder what that chart looks like for London? The bubble here just gets worse and worse. Especially given the influx of untaxed and unregulated hot money from abroad.


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