Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 21 January 2020

Evidence and the persistence of mistaken ideas: the case of house prices

Another paper, this time from the Bank of England written by former MPC member David Miles and Victoria Monro, shows that the rise in house prices we have experienced since 1985 is mainly the result of lower real interest rates. The other, less important, driver is household income. Those two effects together can account for all the increase in house prices relative to inflation. The increase in house prices is not the result of a shortage of new houses.

Those who remember two earlier posts of mine will know of my own conjecture along similar lines. More recently Ian Mulheirn has championed this theory: here he is commenting on an apparently contrary view from Paul Cheshire. The importance of real interest rates to house prices has been understood for a long time: the first time I came across it was when Steve Nickell wrote a paper when I think he was still on the MPC. Very recently, here is Paul Johnson making the same point.

Secular stagnation is used by most macroeconomists to describe the current era where real interest rates appear to be permanently lower than they were decades before. The uncomfortable conclusion would be that as long as this era lasts, house prices will remain at levels that are unaffordable for many young people. Building more houses on any reasonable scale is not going to change that very much.

The reasoning behind the theory is incredibly simple. Houses are an asset. Like any asset, its price depends on the return from holding them (in the case of housing rents) and the rate of interest. The demand and supply for housing services (i.e. a roof over your head) determines rents rather than house prices. Imagine choosing between investing in housing or in government debt (more specifically a perpetuity, so you never get the money back but the interest pays forever), Interest rates on government debt are 2%, so on every £100 K you invest in government debt, you get 2K a year in interest. Suppose the (net of costs) rent on every £100K of house was 2K a year. Then you are indifferent to whether you own either asset.

Now suppose interest rates fall to 1%, but rents stay the same. Everyone wants to become a landlord, and people with money to invest buy houses to rent, because before interest rates rose you are getting double the return you were getting on debt. With perfect arbitrage this will carry on happening until houses that used to be worth 100K are now worth 200K, so that the return to housing again equals the return to holding debt = 1%. House prices have doubled, but the demand and supply of housing services has remained unchanged. The suggestion is that this is the process behind rising house prices in the UK.

That does not mean building more houses (increasing the supply of housing services) has no effect on house prices. Raising supply pushes down rents, other things being equal, and that reduces the return from owning a house, so it will reduce house prices. But the stock of houses is very large, so even with large house building programmes the impact on rents is small. Here Ian Mulheirn shows what the paper by Miles and Munro says about the small size of that effect.

You might say that any reduction in house prices is welcome, but you are using a great many resources (and a fair bit of land) to produce a modest effect. You might get a similar impact on house prices if the government undertook a serious fiscal stimulus, leading to a rise in short interest rates which would have a modest impact on long interest rates, but a noticeable impact in reducing house prices.

My question is why this point is almost never made in the popular discourse on the house price problem? One answer is that housebuilders have a vested interest in suggesting a dire need for more housebuilding, in part because it adds to pressure on governments to free up greenfield sites. This is exactly what has happened since 2010. There is nearly always a vested interest in perpetuating incorrect economic explanations.

In this case, as in others like the supposed need for austerity, there is something else, and that is an apparently simple piece of economics that perpetuates this misconception. With austerity it is that the government should be like a household, which most economists believed before Keynes showed it was false. With house prices it is that prices reflect demand and supply.

The difference between austerity and failing to distinguish between house prices and the price of housing services is that the former is more difficult to challenge than the latter. The reason is that everyone also talks about housing normally being a good investment. That is seeing housing as an asset, so all you need to do to break the misconception is a bit of asset pricing theory.

With issues like these, there are two spheres of understanding, with precious few links between them. There is what I will call the knowledge sphere, where academics (including academic think tanks) and economists in central banks and elsewhere regularly exchange ideas and evidence within that group. There is a second group comprising most of the print media, the broadcast media, some (mainly right wing) political think tanks and most politicians, where again communication within the group is pretty good. 

Communication between the two spheres is sparse. Most political journalists in the broadcast media spend more time watching each other and reading the print media than they do talking to people in the other sphere. Despite many who work hard to package knowledge in accessible ways, often the best those in the knowledge sphere can hope for is an article in the Guardian, FT or Times. If politicians don’t want to access expertise, there is therefore little requiring them to be knowledgeable. The examples I have highlighted are from economics, but I think it is true for all the social sciences.

As a result, politicians can continue to propagate and pursue bad ideas, like austerity is necessary or house building is the answer to high house prices, with little or no challenge in their own sphere. This is not about experts forcing politicians to do what they suggest, but about the public and even politicians being aware of what the evidence suggests. The fundamental problem is not that those in the knowledge sphere don't communicate well, but that too many politicians and much of the media do not want to be well informed. 


  1. Alexander Harvey21 January 2020 at 11:06

    You don't seem to publish comments anymore but in the hope that you still read some of them I wish to say "Thanks".

    Every little helps, and everyone that reads and propagates your message will spread a little reason to those who will listen.

    I have to be a little careful, as I have held similar views for a while, so I am bound to be grateful to you.

    Alexander Harvey

  2. So it is in fact still a question of supply and demand, just not the demand most people think of. Rather than demand for housing services, which I suppose is fairly inelastic, the demand for assets is affecting the big price movements.

  3. Nice theory but that does not neccessaey mean it is true, where are the statistices to prove it?

  4. Very interesting, but how does this explain high rents, not just high house prices?
    Also, this price mechanism seems to work through the buy to rent sector, is that correct?

  5. These sort of discussions - although worthwhile and necessary - tend to cloud and distract from the indisputable reality that the supply of, and access to, affordable housing should substantively increase and improve. The issue that needs to be discussed more is how.

  6. I own one property outright which I rent out. I’ve decided that a fair rent is 5% of the house price per annum before tax, or about 4% after. That way if the tenant had an interest-free mortgage it would take them 25 years of paying rent to buy the house. (Of course, with a real mortgage it would take much longer - possibly twice as long). For the purpose of that calculation I don’t include costs and repairs and overheads except taxes and agents’s fees, since by and large the tenant would have to pay them if they owed the house. So maybe the yield net of all costs is 3%, compared to your given rate for perpetuities at 2%. I appear to be an unusual landlord in that I calculate rent from value instead of by the local supply and demand.

    It shouldn’t make any difference, but perhaps it would if everyone did it that way. In your example, the rent is set first by supply and demand, and that influences the house price (presumably along the lines of house price is 25 * gross annual rent). Your way round if net yield from renting is greater than that from government debt, people try to become landlords and house prices go up until rentiers realise that they’re better off buying the perpetuity. If every rentier did the calculation my way round this causal link is broken (there’s no mention of interest rates in my first paragraph) and in fact prices might actually fall due to the increase in properties for rent.

    An argument for fixing rent at a percentage of value by law?

  7. I see that more folk are accepting the obvious. God, the number of free marketers who have lambasted me for saying the primary determinants of house prices are ease of lending and cost of borrowing SO they say we must concrete over our Green and Pleasant Land... As I have resisted I am obviously a boomer and a socialist/elitist who hates the under 40s...
    Spread the word Prof. I do on my podcast @boomsbusts

  8. This explanation makes sense for the rise in house prices in the UK as a whole, but wouldn't you say that in London (& South East, East) there is a substantial supply issue? House prices in London grew at the same rate as the average UK index from 1979 to 1995, but since then have grown 50% faster... My sense of the housing supply debate is that it's mostly focused on London and the South East (symptomatic of a broader problem in the discourse of course!).

  9. The simple answer is that we are talking about propaganda, not economics. It suits Neo-Liberal politicians to pretend that house building is the answer, because that perpetuates the myth that property ownership is the only answer.

    Clearly most Germans when I lived there rented houses (1969), I personally paid 50 pfennigs per month for a room off my employer, because I worked at the Brewery that owned the properties. When living in North Germany I paid an average of £7 per month for a room.

    On returning home later that year, I paid £7 per week. I have no doubt that things have greatly changed in Germany since then because Neo-Liberalism has encouraged people to buy and rents have proportionately, greatly increased as a consequence.

    Council housing was cheap in the 40s to 1980s until Thatcher's Neo-Liberal doctrinaire policies talked of economic rents, and a property owning democracy. Cheap rents also acted as a natural break on house prices, where private housing was relatively static from the 40s to 70s - due to the obvious inclination of cheap rents being preferential to a mill stone that people now have to burden themselves with. Today mortgages remain a greater burden than previously because house inflation has slowed and wages stagnate, meaning people no longer feel private ownership is the investment that it once was.

  10. Housing attracts additional costs unlike government bonds. Thus housing is a cost centre; depreciation in the quality of the house and local taxation for example. As asset classes I think that the equivalence suggested is incorrect.

  11. This is part 1 of a comment I received from John Muellbauer:

    While interest rates matter a lot for house prices, the emphasis placed by you, Miles and Monro and Lewis and Cumming in
    to the neglect of other factors is wrong.

    One clue: you say “The reasoning behind the theory is incredibly simple.”  Bitter experience has taught me to beware of simplistic arguments in economics. This, like the consumption Euler equation, the efficient market hypothesis, the simple dividend discount theory of the stock market and others…is doomed to failure. Yes, housing is an asset, but it is also a consumption good, which your title denies.

    In Duca, Muellbauer and Murphy 2011 EJ
    and 2016 AER Papers and Proceedings
    we estimated models of US house prices using the above arbitrage model. Had the model been correct we would have found a coefficient of -1 for the real interest rate or user cost in the long-run solution for the log house price/rent ratio. Instead we find coefficients under -0.2 in absolute value.  When there are credit constraints, theory says a shadow price for the severity of the constraint enters the relationship and the coefficient on user cost should be less than 1 in absolute value, as Geoff Meen pointed out long ago
    . We find large effects from US credit liberalisation in the period 1997-2006. Also, the real interest rate that is relevant should be a user cost based on capital gains expectations but, given transactions costs, over what horizon? It is far too simplistic to take indexed bond yields.

    Further, it isn’t just the real interest rate or user cost that matters – so does the nominal interest rate, as we found in the French house price model in Chauvin and Muellbauer (2018)
    . In France, the debt-service ratio (nominal mortgage payments/current income) is widely used as a lending criterion (partly because of financial regulation) making it obvious why nominal mortgage rates matter for housing demand: the cash-flow burden is lower with lower nominal rates and so banks will lend more and borrowers are willing to take on more debt.

    A second clue: you say “Raising supply pushes down rents, other things being equal, and that reduces the return from owning a house, so it will reduce house prices. But the stock of houses is very large, so even with large house building programmes the impact on rents is small.” Acknowledging that rents are endogenous and depend on supply as well as demand is important as it limits what can be learned just from simple arbitrage, even if that were true. The claimed ‘small’ effect is short-termism writ large. Empirical models suggest that a 1% increase in the housing stock, with other things, including user cost, equal, lowers real house prices by around 2%.  In recent years, building has changed the stock by well under 1% per annum, so that on that basis even doubling the rate of building would take a long time to reduce the real price of housing. But differences in the growth of the housing stock relative to income and population growth explain a lot of the divergence since 1980 between house prices in Germany and the UK. One can’t explain the UK-German differentials in terms of bond yields alone. Governments should take the long view – who else?  Furthermore, in principle, since expected appreciation should depend on the supply-demand balance in the future, a change in the supply regime which shifts expectations towards increased future supply could have a more rapid impact on house prices by increasing the user cost.

  12. Part 2:

    Mulheirn’s previous empirical work, presented at the NIESR conference in 2018, is highly non-robust. His first argument against Paul Cheshire rests on counts of homes and households that are misleading, as composition changes in both are large, and the number of households is endogenous. Much better, at the aggregate UK level, is to use the ONS residential capital stock for the supply side, which includes conversions and improvements, and to use population and include some measures of the age structure on the demand side (and of course, a bunch of other variables such as real income per head, nominal interest rates, credit conditions etc). His second point is just an assertion that supply hasn’t constrained household formation. But this is irrelevant in my approach which acknowledges that household formation is endogenous and replaces it by population and age structure which are far less endogenous. Fig 1 in my 2018 NIESR paper
    has a more balanced picture, suggesting that since 1980 around 2/3 of the rise in real house prices is due to income and population growth outpacing growth in the stock of housing. By the way, where housing is built should also make a substantial difference to the national indices.

    I also wonder how these kinds of arbitrage models can handle regional differentials? Explaining the differences in house prices between Knowsley on the one hand and Kensington and Chelsea on the other, in terms of rent differences is likely to be tautological even if it worked. It begs the question of why rents are so different. Can it just be demand? Surely not.

    1. Part 3

      Apologies to the non-Economists. If you want the bottom line, jump to the last paragraph below. The sensible point that Simon W-L and David Miles and Victoria Monro are making is that houses are assets (a form of wealth) as well as consumption items and therefore lower interest rates, other things being equal, will drive up their prices. John Lewis and Fergus Cumming push this too far by claiming that ‘houses are assets, not goods’. This is nonsense: shelter is also a consumption good whether you pay rent for it or whether you pay the mortgage costs (or forgo the alternative returns on other assets by tying up your money in your house).
      Drawing attention to the difference between assets and consumption goods highlights the case of council or social housing. This provides shelter to the tenants but no kind of investment return to them. I mention it because almost 40% of the reduction in house building since 1985 compared to the pre-Thatcher years can be accounted for by the enormous cuts in social house building. Miles and Monro don’t mention this as a factor in their story of high house prices.
      They do mention property taxes as an element in their story of house prices but don’t draw the obvious policy conclusion. The fall in interest rates has undoubtedly contributed to the rise in real house prices. This has made property owners a lot wealthier, widening the gap between property-rich families and non-owners. If we want to make housing more affordable, and narrow this gap, reforming council tax and building more housing are the most obvious solutions. The current form of council tax is monstrously unfair and inefficient. It is unfair because, for example, the recent buyer of a £200 million property in London will pay no more council tax than someone in a £3 million house in the same area. His tax rate as a fraction of value is infinitesimal. For houses below around £3 million (band H), the tax rate is higher, the lower the value of the home. Some people at the bottom can end up paying 2 percent of value every year. Council tax is inefficient because it encourages conversion of multi-family dwellings into single-family mansions, reducing the supply of housing. It is also inefficient because the single-person discount discourages downsizing and the release of housing to younger families. Not linking council tax with recent market values is another cause of inefficiency.
      I’ve long advocated council tax reform, along with many other economists, including the authors of the famous Mirrlees Review of the tax system. One crucial reform to avoid the problem of the cash-poor widow in an expensive home, is to offer occupants deferral of the property tax until the property is sold or transferred. Then there would be no need for a single-person discount. Apart from revaluing homes regularly, and making the tax fair - reducing the tax burden for the bottom 75% of families but increasing that on the top 25% - I am also keen to introduce a green element: a discount for dwellings with a low carbon footprint. This would encourage ‘greening’ of the housing stock, which we need to meet the UK’s carbon-reduction goals. You can read more about this and on how better land-value capture could increase the supply of land and reduce infra-structure costs in my 2018 NIESR paper, also available as an Oxford Economics department working paper.

    2. Part 4

      One other point worth mentioning is that Miles and Monro emphasise the 35-year decline in long-term real (inflation adjusted) interest rates. This allows them to disassociate that decline from monetary policy pursued across the globe after the financial crisis. But, as
      I explained in my first blog, the theory they and Lewis and Cumming use to make their point is overly simplistic. Cash-flow affordability measured by the cash cost of servicing a mortgage out of income also matters for explaining the demand for houses. In the UK, most people still have adjustable rate mortgages or relatively short fixes. This means that the low policy rates set by central banks contribute to explaining why house prices are so high and why wealth has become more unequal. It isn’t just a story of low long-run real interest rates.
      To summarise: don’t believe for a moment that sky-high house prices are an inevitable natural phenomenon. Policy choices are crucial. As a society, we can build more social housing. We can help control demand and make better use of the existing housing stock with sensible and fair taxes. And we can release more building land and reduce the burden on ordinary tax payers of financing schools, roads and social housing with better land-value capture.

  13. Can't agree fwiw. The late 70s / early 80s were the absolute peak (for 000s of years) for inflation and interest rates (gilt 10 yr). Plummeting rates for decades, soaring house prices.
    Rising rates into ERM, falling prices.
    Then when rates bottomed 2009/10, they dreamed up Communism aka Help To Buy. Lending soared. prices soared.
    all best

  14. Aditionally, the failure to capture ground rent publicly,advocated by Adam Smith, David Ricardo, JS Mill, Henry George, Mason Gaffney, Michael Hudson, Joseph Stiglitz, et al, leaves rent in private hands being capitalised into ever-increasing land prices.

  15. I speak as a general reader, not an economist, and I have regarded your blog as one of the few precious links between the two spheres you describe. Your article seems clear and contains a surprising message - I have long thought that the level of house prices was a consequence of the lack of house building. The comment from John Mullbauer is much harder to understand, partly because of the many references to other articles one would have to refer to to understand fully, but it seems he disagrees with the main conclusion of your article. How is a non-specialist to come to a conclusion about which is correct?

    This seems to me to be a good example of the difficulty of bridging your gap between the two spheres.

    1. Jonathan Clark is absolutely right. Sometimes the body of expert opinion is so skewed in a particular direction that it is not unreasonable for politicians and the general public to take experts at their word, and act accordingly. However it is clear that on this subject expert opinion is divided, so what are we non experts to do?

  16. I agree 100% with this. I have long thought that the shortage of houses argument was completely bogus and had an ulterior motive of obtaining a relaxation of the planning laws in order that the housebuilding oligopoly could enhance their profits.

  17. Housing as a demographic ponzi scheme. Discuss.

  18. It is certainly true that very low interest rates have significantly increased house prices. Undoubtedly a shortfall in supply is an important issue too - maybe not overall in the country, but in places where people actually want to live. And not just in the UK. Compare the situation in wealthy inner London with that in Northern Ireland - same mortgage rates, but much more constrained supply with the Green Belt in the former than the latter. And, unsurprisingly, prices in London are several times those in Northern Ireland - much more than you would expect given the differential in incomes.

    Same in the US - look at San Francisco vs Houston. Incomes and interest rates are important, but so is supply.

    We also need to build better quality and larger houses, but that's a separate issue.

  19. Another point - a reason why very low interest rates did not cause an increase in economic growth post-2008 was that it is so difficult to build houses. Compare with the 1930s, when very low interest rates caused a building boom across the south and midlands. But Green Belts, introduced subsequently, mean that new building is far more difficult and land you can build on is far more expensive. So the house building boom which should have carried us out of recession more quickly did not happen this time.

  20. Building more quality houses certainly will change things.

    In SE England, London and increasingly parts of SW England, with population growth and a fairly static housing stock, everyone has to 'budge up' and compromise. People in every socio economic group move into smaller and less attractive housing than their parents. That has been going on for decades, to the point that unless you inherit, experience massive economic upward mobility, or move to a gentrifying area, your quality of life will almost certainly be lower than the previous generation (in housing terms at least).

    In other areas, Northern Ireland for example because I know it, there has been a great deal of building of quality houses, so the housing stock has pretty much kept up with population growth. This means that, should they wish to, most people can afford to live in the same kinds of houses and areas as their parents. Obviously some choose to move out from Belfast to the countryside, where a lot of high quality new houses have been built. This takes the pressure off established areas, so their prices have not got out of hand.

    Of course low interest rates mean that prices settle at a higher equilibrium price, as everywhere else, but 'average' people can still live in 'average' homes like their parents, due to the increased quality supply.

    Also, there are no very large housebuilders in Northern Ireland, instead there is meaningful competition on quality between smaller housebuilders. And there is no shortage of skilled people, who are often to be found working on high end projects in London.

  21. Many thanks, but no mention of tax. We did not have near-parabolic increases in house prices when imputed rent was taxed under Schedule A, as it was between 1802 and 1963 (and, more effectively, up to the commencement of WWII when the last quinquennial valuations were still effective). Nor is there any mention of the exemption of the primary place of residence under the CGT (from 1965). These, together with the liberalisation of credit after 1971 (the elimination of the corset with the BoE's Competition and Credit Control) must be among the most decisive factors. Remember that the population was stagnant or falling in the late 1970s and 1980s (though household formation was stable or increasing with rising divorce) but house prices still rose very rapidly.

    So it has to be the case that a very large proportion of house prices increases since c. 1970 are attributable to the fact that the Macmillan and Wilson governments created the legislative and fiscal conditions that permitted house price speculation, and the liberalisation of credit allowed that speculation to be financed. The consequences of this have had a drastic impact upon almost the entire British political economy. The failure of economists and economic historians to cover this has been striking, though there is - finally - a brief discussion on Schedule A abolition Martin Chick's 'Changing Times' (the latest instalment of Oxford economic and social history of Britain).

    Also, having visited about 8,000 parishes over the last decade I can assure readers that there has been a radical increase in housebuilding, whilst the impact this is having on the landscape and, arguably, the environment (since most new developments will be of a dormitory nature accessed via car), must be problematic. In addition, since a very large proportion of the land of the British isles is uncultivatable upland waste, the accelerating sterilisation of high grade agricultural land by development (as categorised by Dudley Stamp's land utilisation survey) is also of doubtful benefit. So, when people assert that only 10-13% or so of the land is under concrete, you should account for at least a further 10% that is blighted by its proximity to developments, and the large percentage which cannot be cultivated.

  22. I think low Interest rates are indeed part of the problem. Another problem causing soaring house prices is the supply & demand myth itself, be it that building more houses actually increases prices:

    My locality has seen a glut of new builds over the last 5 years, and prices for the area have shot up not come down. Yet the supply has increased, how so? This area is far from being an economic boom town, so what else is at play?

    The supply of LAND. Land is the greatest denominator of house price, it's also quite finite. You can’t increase the supply of land in a factory, so once a dwelling has been built, that land allocation is gone (unless the dwelling is knocked down of course). So, it stands to reason that the more houses are built, the scarcer buildable land becomes and so more expensive to acquire. Which of course feeds on to higher house prices.. There’s no getting round this.

    So instead of building more houses (and potentially exasperating the issue) how about looking at those who speculate/hoard land and/or properties? Which of course circles back round (in part) to low interest rates.

  23. We can cut house prices with a 100% land value tax replace other taxes. House prices will fall to price of buildings as land prices fall to zero.

  24. My instinct is that this view underestimates (disregards?) the shift from social housing and the sale of council housing, alongside reduced supply.

    Surely it matters whether the supply is for private sale versus supply for rent by councils (at below market rates).

    The effective removal of council housing, the sale of council stock itself into private hands *and* a low level of housebuilding surely contribute quite significantly? Add a low level of interest rate, increased changing of hands (reduced occupation time before moving home) due to increased labour mobility ("get on yer bike"), and fears about the security of other investments (pensions for instance) then it hardly seems surprising.

    Any support for this view?


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