This post starts off talking about the UK, but then goes global
We are all used to seeing graphs of house price to income ratios. Here is Nationwide’s first time buyer house price to earnings ratio for the UK and London.
|UK First time buyer house prices relative to earnings: source Nationwide|
Housing is becoming more and more unaffordable for first time buyers. Yet prices are currently booming (at least in London), and demand is so high estate agents are apparently now holding mass viewings to cope. In the UK the media now routinely call this a bubble, and the term ‘super bubble’ is now being used. London may be a bit unusual (see this extraordinary research), but it can also be a leading indicator for UK prices in general.
Bubbles are where prices move further and further away from their fundamental value, simply because everyone expects prices to continue to rise. One of the earliest and most famous bubbles involved tulip bulbs in the Netherlands in 1637. Yet that bubble lasted less than a year. The dot-com bubble lasted two or three years. If you think there should be some underlying constant value for the house price to income ratio, then this UK housing bubble has been going on for much longer than that. Instead of being pricked by the 2009 recession, it merely seems to have paused for breath.
Yet does it make sense to compare house prices (the price of an asset) to average earnings or incomes? A more natural ratio would be the ratio of rents (the price of consuming housing) to earnings, and this has been relatively stable over this period. Or to put the same point another way, the ratio of house prices to rents has shown a similar pattern to the ratio of house prices to incomes shown above. (The Economist has a nice resource which shows this, and covers all the major countries besides the UK.)
If we think of housing as an asset, then the total return to this asset if you held it forever is the weighted sum of all future rents, where you value rents today more than rents in the future. Economists call this the discounted sum of rents. (If you are a homeowner, it is the rent that you are avoiding paying.) So why would house prices go up, if rents were roughly constant and were expected to remain so? The answer is that prices would go up if the rate at which you discounted the future fell. The relevant discount rate here is the real interest rate on alternative assets. That interest rate has indeed fallen over much the same time period as house prices have increased, as Chapter 3 of the IMF’s World Economic Outlook for March 2014 documents.
Think of it this way. You believe that the return you get from owning a house (the rent you get or save paying) will be roughly constant in real terms. However the return you get on other assets, measured by the real interest rate, is falling. So housing becomes more attractive as an asset. So more people buy houses, and arbitrage will mean its price will rise until the rate of return on housing assets adjusts down towards the lower rate of return on other assets. As Steve Nickell pointed out in 2004, if the expected risk free real interest rate permanently fell from, say, 4% to 2%, this could raise real house prices by 67%.
It is the expected return on other assets that matters here. The fact that actual real interest rates have fallen in the past would not matter much if they were expected to recover quickly. A key idea behind today’s discussion of secular stagnation is that real interest rates might stay pretty low for a long period of time. That in turn implies that house prices will be much higher relative to incomes than they were when real interest rates were higher.
So what appears to be a bubble may instead be a symptom of secular stagnation. We can make the same point by looking at another measure of affordability, again provided by Nationwide.
|UK First time buyer mortgage payments as a percentage of mean disposable income: source Nationwide|
First time buyers are able to afford elevated house prices, because interest rates on mortgages are so low. Of course raising the deposit is a problem, but the government’s Help to Buy scheme has come to the rescue by effectively restoring the 95% mortgage that disappeared in the recession.
Secular stagnation is a global idea, so if this story is right then we should see similar patterns abroad. Using the Economist as a guide, I think we can split countries into three groups. The first group is the UK, France (which looks very much like the UK!), Belgium, Italy, Sweden, Canada, Australia and New Zealand. There the house price to income ratio rose sharply in the 2000s, and has stayed high. The second group is the US, Denmark, Ireland, Netherlands and Spain, which also show large increases in the 2000s, but where post-recession declines have been so large as to actually wipe out (or come close to wiping out) these gains. For these countries it could be a bubble, or it could be an underlying rise temporarily offset by the impact of the recession. The third group is Germany and Switzerland (and maybe Austria), where the ratio has been falling over time, but has picked up over the last five years. There is one outlier, Japan, where the ratio has been falling since 1990. In a nutshell, the data is not clearly consistent with the secular stagnation story but does not clearly reject it either (ever thus!)
Does this mean we should stop calling what is happening in the UK a bubble? The first point is that secular stagnation is just an idea, and it may prove wrong, and if it does house prices may come tumbling down. Second, even if it is not wrong, it is still possible to have a bubble on top of the increase implied by lower interest rates. Indeed one of the concerns about the lower real interest rates associated with secular stagnation is that, by raising asset prices not just in housing but elsewhere, it may encourage bubbles to develop on top. So all we can say with certainty, for the UK at least, is that the Financial Policy Committee will have their work cut out when they next meet in June.