Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 25 May 2016

Household debt and house prices

In previous posts I have talked about why I am suspicious of (but not completely opposed to) the idea that the UK (or US) has a serious problem because there is too much personal debt. Too much popular discussion goes as follows: booms and busts are often caused by excess lending and borrowing, household debt to income ratios are currently high compared to a few decades ago, and so we must be on the verge of a new personal debt crisis. The first two points are true, but the third does not follow because of one thing: house prices.

I thought I would illustrate the key point with a graph, based on data from the OECD’s Economic Outlook.


The yellow line is house prices relative to income: the absolute level is arbitrary. The red line is mortgage debt as a ratio to personal income, and the blue line is the total debt to income ratio. The green line is the difference between the blue and red i.e. non-mortgage debt relative to income.

The key point is that most of total household debt is mortgage debt, and this follows house prices. That the two should track each other over the long term is not surprising, but the fact that mortgage debt seemed to fall exactly with house prices is. (If house prices fall, this changes the value of new mortgages, but not the value of existing mortgages.) The reason may be that in the short term the interaction is two way. A fall in the demand for house purchase (and hence mortgages) will impact on price. Non-mortgage debt is now a little lower relative to income than before the crisis.

The basic story is therefore very simple. The main reason people go into debt is to buy a house. The more expensive houses get, the more they have to borrow. If there is a problem, it is not that we have all gone on unaffordable spending sprees. It is that house prices have been rising. Rising house prices increase not only household debt but household wealth, which is a key reason why wealth was also rising rapidly before the financial crisis.

The picture for the US is similar, except that non-mortgage debt has returned to pre-crisis levels.


This suggests no near term risk of any private debt crisis. Indeed for the UK, as Chris Giles reminds us, 2008 itself was not a crisis about personal debt, but a crisis about UK banks overseas lending. As a result, talk about private debt nearing ‘2008 crisis levels’ in the future is highly misleading.

There are two reasons why house prices have been rising in the UK: not enough houses are being built and real interest rates have gradually declined (secular stagnation). As governments have relatively little control over long term real interest rates, you will only reduce mortgage debt by reducing house prices by building more houses. To put it very simply, the aggregate private debt problem in the UK is a reflection of our longstanding inability to build houses.

That is a serious problem, and not just because it prevents a lot of potential first time buyers from being able to afford to buy. It means that, if interest rates were to rise significantly, households with mortgages would be spending much more of their income paying off the mortgage, and they would be more vulnerable to shocks to income as a result. One of the problems with the recent relatively slow growth in nominal wages is that the real burden of a fixed nominal mortgage has not been falling much as the mortgage grows older.

Worse still, if real interest rates did start to recover (secular stagnation proved to be less permanent than many people currently think) this would in itself tend to reduce house prices. That could leave many relatively new home owners with a mortgage larger than their house was worth. In the UK people cannot walk away from this negative equity. Equally lenders could have loans that were no longer covered by the value of an asset. Deflation coupled with rising real interest rates is a toxic mix. But all of these problems reflect the fact that house prices are currently too high. [1]

I think the simple takeaway is this. Anyone who talks about the growing problem of total private household debt without also talking about what has and what will happen to house prices is missing the elephant in the room.

[1] It is tempting to write that high levels of private debt are a symptom rather than a cause of these problems. That is too strong: people choose to take out a mortgage to buy a house rather than rent. However as most people only own one house, it has an element of truth. It seems odd to argue that an irresponsible debt fuelled increase in the desire to own houses is pushing up house prices.

24 comments:

  1. Simon. Completely follow your logic. But one of the features of the current boom in house prices in London and elsewhere is the level of speculative activity and BTL 'investment' funded by lending and cash. This activity is highly sensitive to expected house price growth and of course interest rates. We are now in more dangerous territory when faced with an economic shock. Ironically if house builders did decide to build far more houses at present (most unlikely) we would compound this house price risk.

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  2. I think you are missing two things in the analysis (I appreciate it's a blog post and you cannot mention everything)

    (1) the plan is for household indebtedness to go up even further by 2020. That is Mr Osborne's plan, as set out by the OBR. So, what would that mean if indebtedness of the private sector increased even further, to the heights reached in 2008?

    https://twitter.com/rad_econ/status/643431849985970177

    (2) The problem with the housing market is that in 2008 73% of properties were owner-occupied, now it is only 65%.

    Both these trends point only to one thing. Increased inequalities, and shift in wealth from younger renting generation to older buy-to-let landlords.

    Rent extraction sanctioned and planned by the party for the old-age rentiers of society, the Tories.

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  3. "Rising house prices increase not only household debt but household wealth.." Yes. If you assume that the price at a moment in time is a standing option to cash out. Now I know that the same could be said for every other asset, but we really need to remember what (IIRC) Andrew Oswald said back in 2004. In 2007, long before the collapse, I suggested in Glasgow's Herald that reason had "left her throne". Every economist understands substitute goods, and while renting and buying aren't perfect substitutes, they're very good substitutes and not all of the differences mean that owning is better. So we knew in 2004 that as prices soared and rents went nowhere we had a bubble. If interest rates were 3% above inflation, as they normally will be, there would be the most almighty bang in the housing market. We've had the banks "extend and pretend" to avoid admitting what we all know, and we're spending a fortune on Housing Benefit, Council Tax Benefit and help for impecunious mortgage holders all to pump up an asset class that has been the cause of most of our problems for decades. People think in cliches. How boring is it to hear the British talk about how "it's as cheap to buy as it is to rent", "rent's just dead money", "you've got to get on the ladder". There's no end to it, and the economics profession could do a useful service by spending a bit of time explaining why owner occupiers are their own landlords, and why - even after you've paid off the mortgage - it's still costing you a fortune in rent forgone, income from alternative assets forgone and maintenance costs to stay in the property.

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  4. Oh my, my, aj aj aj aj

    Your post shows how an excellent economist can have a picture of an imaginary modeled world not a world that we live in. You should talk with loan officers a bit more to find out how loans work.

    How the same person can write these twosentences in the same post?;"most of total household debt is mortgage debt, and this follows house prices. That the two should track each other over the long term is not surprising, but the fact that mortgage debt seemed to fall exactly with house prices is."

    and this one;"One of the problems with the recent relatively slow growth in nominal wages is that the real burden of a fixed nominal mortgage has not been falling much as the mortgage grows older. "

    So you are aware that it is all about the burden of debt, not at all about debt to income ratio. But yet, the first sentence doesn't show anything about burden of debt/ monthly payments levels/ percentage of income to service debts, it only talks about debt/income ratio which is irelevant.

    First and very important, it is the debt that controls prices not that prices are independent of mortgages as you postulate here. It is bank's terms that they offer to homeowners fully and completely control the prices if income is fixed, AEE.

    Please, do not asume barter economy where demand and supply give prices, should not almost ever. We are in MONEY-DEBT-BARTER economy. When you economists will grasp this reality? When demand and supply afect the price in capitalism/ today's world it is called an economic shock, like oil shock etc.

    Banks fully control the house prices and every loan officers is aware of that fact. It is trough the system of commission to loan officers that prices will always go for the fullest possible hights as income and MORTGADGE TERMS allow for. Loan officers and real estate agents will push for highest prices that income of their clients (or targets as loan officers tend to call them) if banks and mortgage companies let them to.

    You are probably not aware of the scandal that was quickly hidden in 2001 about RE agents blacklisting apraisers that did not give highest apraisers on house prices in US.
    I heard about it in 2005 when i became a loan officer, it was more then 2000 apraisers' signatures complaining to Senate about being blacklisted from apraising because they did not offer apraials that were to RE agent and loan officer's liking.

    This apeared in newspapers only in 2009 after the scandal broke out while questioning why banking collapse happened. But it was quickly forgoten.

    Again, it is in bank's full conttrol about hosue prices. There is no barter economy where demand/supply control prices which would be called a shock if it happened. We are in MONEY-DEBT-BARTER economy.
    That is what Steve Keen is trying to teach you mainstream economists and he shows that acceleration of debt is directly corelated to unemployment and growth. Also that margin debt levels control stock prices.

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    1. That formatting style reliably correlates with displays of Dunning-Kruger.

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  5. You say "people choose to take out a mortgage to buy a house rather than rent".
    But in my experience both are about equally expensive, and at least if you buy then at the end you'll have an asset to show for it.

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  6. This sentence proves why mortgage to households must be fixed rates, not adjustable;" It means that, if interest rates were to rise significantly, households with mortgages would be spending much more of their income paying off the mortgage, and they would be more vulnerable to shocks to income as a result."
    It says that banks offering mostly adjustable rates for mortgages can cause recession. So in US they call it subprime crisis which is about the shift from prime/fixed to subprime/ adjustable mortgages that happened around 1998 which banks pushed through deregulation. Before 2000's most of the mortgages in US were fixed loans which is also called prudent banking. Later banks could offer higher apraisals (higher prices/loans) as interest rates declined long term. When this trend was not enough they offered loans for downpayments for first time homebuyers. Now first time homebuyers did not have to wait to save for downpayment which enabled even higher prices. As new solutions to ever higher house prices reached the limit, banks would (thanks to deregulation) soon find a new solutions so it came to NINJA loans, flexible payments and baloon payment mortgages that were previousy allowed only for house builders. All of it enabled by deregulation of banking and unscruable ability of commission based employees to fudge for higher commission pay.

    That sentence also implys that adjustable rate loans affect profit rate for firms too and can bankcrupt them. Why are economists not aware of that fact? This fact is the most crucial one for business cycle yet economists are still puzzled about it. Is it because it was Marx that first tought of that and so he is banned from mainstream thought?

    Why economists are not aware of how capitalism came to exist? It is by invention of debt money creation that capitalism was enabled to start. In feudalism people had to save/ wait for 20 years to save to be able to buy something. When banks invented credit money out of thin air that wait time was over, and everybody could get credit for enterpenurial idea and buy and start a start up which enabled inventions. This is how capitalism was allowed to come about; by out of thin air credit creation. But economisits still think like it is stil feudalism where banks are saving/loan intermidiary.

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  7. This sentence; "
    Worse still, if real interest rates did start to recover (secular stagnation proved to be less permanent than many people currently think) this would in itself tend to reduce house prices. That could leave many relatively new home owners with a mortgage larger than their house was worth. " makes no sense.

    If secular stagnation is over, which means that credit growth resumed and with it prices and most probably wages.

    Two things allow for higher house prices: terms of a loan and WAGES. If secular stagnation is over then soon employment improves and wages with it which enables for higher house prices. Wage push inflation is what is NECESSARY for debt economy to grow continuosly, because it reduces the burden of debt over time. QE achieves asset push inflation which is distortionary long term. But still CBs did not relent from achieving higher inflation. Is it a question now why inflation is needed? Inflation is NECESSARY ingredient of growing debt economy. But wage pushed inflation, not asset price inflation.

    Everything is about the BURDEN of debt in debt economy which is the real world we live in. Inflation and institutional reducers of burden of debt such as interest tax deduction is NECESSARY part of an economy, inflation as debt forgivness over time. Wage pushed inflation and debt forgivness in bankrupcy is automatic mechanism that drives growth and prosperity of capitalism, everything else just comes from human nature that simply follows credit-money creation and distribution of it. Banks controll all of it.

    Even Moses wrote about importance of debt forgivness/ jubille so that even Jesus gave those words into the biggest prayer Holly Father, yet it keeps being forgoten. Occasionaly it is learned and used to create an empire and then forgoten till colapse of empires. Roman empire collapsed because they forgot, British Empire collapsed over time because they started to believe what they tought to their colonies and forgot how the Empire came about, now USA is on the way.

    You can call it secular stagnation as an excuse but it is about forgeting how money-debt-barter eonomy should work. It is all about inflation that is reducing the burden of debt over time/ creeping debt forgivness.

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  8. Prof W-L,

    I agree with the basic thrust of your article, but have a couple of reservations. First, re your claim that one of the two main explanations for house price increases is lower interest rates, that doesn’t sit easily with the fact that UK house prices have DOUBLED in real terms in the last 20 years, whereas they haven’t budged in Germany and Switzerland. But the two latter have presumably experienced the same interest rate fall that we have. (My source of real house price changes is The Economist House Price Index – available online).

    Second, there are two or three other important factors contributing to house price increases: 1, immigration, 2, the fact that more people want to live alone, 3 Nimbyism, which makes it difficult for local authorities to make land available for housing.

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  9. We need to distinguish between personal and private debt, as the latter includes business debt, both financial and non-financial. In the run up to the financial crash, personal debt rose sharply but less rapidly than financial sector debt. Today, although regulation is restraining bank debt, ‘shadow banking’ seems to be growing rapidly to circumvent those constraints and there are very likely hidden risks in that.

    On personal/household debt:
    - your graphs end in 2014 but debt has continued to rise since then, with UK consumer credit rising by around 9% in 2015, although mortgage debt rose by only around 3%
    - as the rate of owner occupation is declining and the rate of house purchase without mortgage is rising, mortgage debt is concentrated in fewer households
    - the UK has not yet experienced a repossession crisis owing to the sharp fall in interest rates which has held down repayments but a rise in rates would expose those on variable rates
    - the household savings ratio rose sharply after the crisis to 11.6% in 2010 but has since fallen to 4.2% in 2015 (a historic low), giving a significant stimulus to demand that cannot be expected to continue

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  10. 1. Surely the causality isn't house prices > mortgage debt, but increased credit availability > more affordability > higher prices?

    2. You observe "rising house prices increase not only household debt but household wealth". Given you point out that the increase in mortgage debt has kept up with the increase in house prices, it doesn't seem that housing wealth has actually increased that much in aggregate.

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    1. The BOE estimates net housing equity withdrawal. The most recent report shows consistent negative withdrawals since 2008. That is an aggregate picture showing higher total wealth, but without clarification as to the state of a median, or an average, household's balance sheet.

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  11. "As governments have relatively little control over long term real interest rates, you will only reduce mortgage debt by reducing house prices by building more houses."

    They don't have the right diagnosis - based as it is on price for lending rather than what can be lent, to whom and for what.

    See how the New Zealand Central bank deals with a property bubble - increases deposit requirements and reduce loan to value levels:

    http://blog.shelter.org.uk/2015/06/time-for-the-bank-of-england-to-join-the-macroprudential-party/

    What is needed desperately instead is asset side regulation of banks. If a bank loan does not meet certain criteria it becomes a gift.

    Personally I think the *only* reason we should pay bankers to do anything is if they can demonstrate the skill of underwriting capital projects against a prospective income stream.

    In simple terms this means somebody going into a bank with a proposal that requires a certain amount of money. The bank staff considers whether the prospective income stream proposed to repay that money is adequate to repay the loan and pay the wages and costs of the bank - including a reasonable return to whatever risk capital underpins the bank. Note that there is no asset collateral involved in this process.

    The way I would narrow banks is to offer them an incentive - an unlimited cost free overdraft at the Bank of England. 0% funding costs. In return they must drop all the side businesses and just do capital development lending on an uncollateralised basis - probably in the form of simple overdrafts. In other words they become an agency businesses delivering state money to those that require it.

    A capital buffer is possibly not required here. Losing your lending licence if your underwriting isn't that good should be sufficient incentive to run a tight ship. Backing off the entire thing to the central bank reduces the barriers to entry in lending - making self-employed, highly dispersed and, importantly, locally focussed underwriters a possibility.

    Any lending businesses that doesn't want to take the oath, then has to fully fund their lending on a maturity matched basis Zopa style. No deposit insurance, no access to the Bank of England, and losses absorbed by those doing the lending. This then becomes the fate of the shadow banking system - the building societies and money funds.

    Any thoughts?

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  12. Thanks for this. Really interesting. At the risk of being sycophantic, I think it is also a nice illustration of what's wrong with our media. As you often note, so little in the press is informative.

    The one comment I would like to make is how much private debt may increase as the OBR's figures show this is necessary for the government to achieve a balanced budget.

    AFZ

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  13. What likely scenario leads to an increase in real rates without a concomitant rise in income (and therefore more money to service debt)?

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    1. That scenario is most likely in depression with deleverage going on and when interest rates can not go further down otherwise called ZLB. That is for countries with floating exchange rate which is mostly former empires.
      For "former" colonies that fix their exchange rate that is a normal occurence where due to much of monetary incompetence CB raise interest rates under excuse; "in order to atract more foreign capital" or to fight inflation that is caused by fixed exchange rate, not by economy itself. This makes matters much worse which then rquiers IMF to jump in and make it even worse.
      Countries with fixed exchange rate and trade deficit (most of them) are under consistent scenarios of rising real rates without increasing rise in income which keeps them in underdeveloped and colonial position of currencies that they fix onto. They fix their currencies under the excuse that all will be solved if we fix the rate which is opposite of the reality. Fixing the rate is the biggest reason for their problems ANd not knowing about Taylor rule and Philips curve.

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    2. Maybe reductions in bond market liquidity, or an increase in expected inflation volatility. I dunno, is there consensus about the causes of lower real rates across most developed countries since the 80s?

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  14. "In previous posts I have talked about why I am suspicious of (but not completely opposed to) the idea that the UK (or US) has a serious problem because there is too much personal debt."

    Indeed. Let's look at the flip side.

    Suppose median US household income is $52k.
    Median US house price $187k.
    State college annual all-in cost $25k. (from NCES, seems low)
    Retirement income required $35k.

    With interest rates near zero, let's PV these by summing.

    Lifetime income 30 years: $1.5m.
    House: $187k
    College for one child: $100k
    Retirement: $700k

    So the net lifetime income available after necessary expense/investment is some $513k, which is some $17k annually for a working career, to cover all living expense and taxes.

    It is possible that debt is not the problem, but lack of income certainly is a problem. It is easy to understand how debt tends to substitute for income.

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  15. I am not an economist... but I think the argument is twofold. First, you have what you have discussed above, rising house prices and paying the mortgage captures a greater proportion of disposable income, therefore consumer spending is down.

    But the second argument is that the pre-2008 boom was driven in part by rising house prices experienced by people already owning houses, who taking advantage of the equity increase, remortgaged properties/got home equity loans, monetizing the rise in price and not necessarily investing the money they took out of the property, but spent it. This contributed positively to consumer spending and "the boom."

    With the 2008 housing crash, that equity disappeared, people lost jobs and were unable to pay mortgages, etc.

    While housing prices have rebounded in certain places with high place value qualities, in many parts of the country, especially in suburbs values remain low, and people aren't able to refinance.

    There have been articles in the Washington Post about low housing prices in African-American dominated areas of Greater Atlanta and Maryland. Although I wonder how much of this is because the locales have low place value quality: I haven't gotten a good answer from anyone.

    http://urbanplacesandspaces.blogspot.com/2016/05/housing-roundup.html

    This contributes to the decline in consumer spending we are experiencing now.

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  16. seems to me that
    artificially low interest rates set by government have caused investors to put their money into real estate
    and this has caused a huge real estate bubble
    somehow this simple notion seems to be absent from your analysis

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    1. Interest rates are 'naturally' at zero.

      Houses returned to their natural value. It is the state paying free corporate welfare in the form of coupons that keeps the price of stocks and other assets suppressed.

      The problem with the current 'drop interest rates and hope people borrow' approach is that it relies upon people wanting to spend and buy something.

      Are they buying the right things? They wouldn't be buying new roads and railways for example. That's why even SWL says you need fiscal policy.

      All these approaches are wrong as they are based as it is on price for lending rather than what can be lent, to whom and for what. You have to control bank lending.

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    2. First, ALL interest rates are artificial. Whether high or low, IR are always arteficial. After you disabuse yourself from the notion that IR can be "natural" or set by "free market". All IRs are set by Central Banks/ by people hence it is arteficial.

      Secong, investors do not invest their money. They only invest loans, it is too risky to invest cash into anything, Loans can default and declare bankrupcy of that investment.
      Loans are in ful control of banks, so it is banks that control where to invest as they aprove loans.
      Since banks decided to lend only against colateral, already existing colateral, and they decided that such loans would have lower interest rates then investing in new ventures.
      It is deregulation that allowed banks to control where it will be invested. Your "blame the government for everything" is just funny. It is "free market" that decided to invest into RE bubble. It is decision of investors (as you presented it) or banks, private banks, not government. You say "caused investors" HA HA HA HA HA HA HA HA HA HA HA HA
      What do you imagine where do you live? In China or USSSR where governments did that by orders?
      Your "blame government" is ridiculus notion.

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  17. "There are two reasons why house prices have been rising in the UK: not enough houses are being built and real interest rates have gradually declined (secular stagnation)"

    I'd like to know whether "not enough houses are being build" is really true. Granted, it is being endlessly repeated across the media, but I haven't seen much data on it. Simon doesn't cite any either. Why is this an unquestioned truth?

    Perhaps he means "There's too much demand for housing"? Now that I can agree with, but demand is potentially infinite - it can come from overseas investors, dodgy oligarchs parking funny money in London prime property, buy-to-let speculators leveraging gains from previous property speculation etc. but this is not evidence of a lack of house building.

    I'd like to see some data on the number of UK dwellings vs number of households. I'm assuming both are increasing, but is one really so out of kilter with the other? It seems like it's a claim that needs substantiating before making proclamations about causation?

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  18. Hi,

    Could any one please share the debt to income data which is referred to in this blog. I tried sea searching in the OECD website but couldn't search through. Thanks in advance.

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