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. 

Economists are losers so ignore them on Brexit

That essentially is the argument of the Telegraph’s Allister Heath, expressed as Donald Trump might. Heath says we have a been failures for over a century, “yet they now have the chutzpah to behave as if they should be treated like philosopher kings, an all-knowing “profession” that we are all supposed to bow down to uncritically.”

Actually right now I think we would settle for being heard. Ironically the only people in the media who seem to have noticed our Times letter are those supporting Leave. This matters. Recent polling evidence suggests voters have taken on board the Bank of England’s view that we will be worse off in the short term. But when it comes to the economy in 10 to 20 years time, as many voters think we will be better off by leaving as think otherwise. That the overwhelming majority of academic economists think there are significant long term costs to leaving might therefore be useful information for voters: information many currently do not have. So much for “philosopher kings”.

Of course economists have many faults and do make mistakes. But it remains the case that economists do know more about what determines trade and foreign investment and the impact of migration than most. We certainly know more than political journalists.

Should our expertise be ignored? Let’s look at some of the evidence Heath uses to suggest we nearly always get it wrong. The first is a poll conducted by the Economist in 1999 about whether the UK should join the Euro. Here the split was basically 2 in favour for every one against. But there is a crucial difference from Brexit. In the case of the Euro every economist would acknowledge (see the Economist article) that there were good arguments for and against. In the case of Brexit the only matter to discuss is how big the costs of leaving are. Our trade can only decrease following Brexit. Foreign direct investment can only decrease. Migration, which is also a plus for the economy as a whole, is likely to decrease following Brexit.

The main argument those supporting Brexit use to suggest the economy will do better is that we can get rid of all those pesky regulations that are holding business back. Which was exactly the argument the Conservatives and those in the financial sector made when they championed reducing regulations on finance before 2008. It worked for a few years, and then we had the financial crisis that led to the biggest post-war recession. Mr. Heath has the chutzpah to lay all the blame for that on economists.

But let’s roll the Euro story on to 2003. The government had to make a decision, and this focused on the economics. It commissioned a huge amount of work looking at all the evidence, consulting widely among academics. These studies flagged up some (not all) of the vulnerabilities of the Eurozone that became evident in subsequent years. This persuaded first Gordon Brown and then Tony Blair to say no. I would count that as a definite win for economists.

Of course he mentions what he calls the ‘infamous’ letter from 364 economists in 1981 criticising the Conservative deflationary budget. We are told that the 364 got it wrong because the economy started growing shortly afterwards. This is mediamacro logic, just like when we were told austerity was a success in the UK because the economy grew in 2013. As Steve Nickell pointed out in this speech, unemployment peaked not in 1981 but 1986. The combination of monetary and fiscal contraction in 1981 was overkill, and on that fundamental point the letter was right.

But I will concede this. Mr. Heath and his colleagues on the neoliberal right are much better at PR than economists. They have managed to create the perception in the media that the letter was wrong and Mrs. Thatcher was right. Their strategy is that if the evidence is against you, distort the evidence.

This is the real beef that Mr. Heath has against economists: we mostly follow the evidence and not an ideology. Most economists were indeed wrong about the Great Depression, but that led to the creation of macroeconomics as a separate discipline under the guiding light of Keynes. This helped produce a golden age of growth after WWII, a fact that Mr. Heath ignores. It was brought to an end by stagflation, but that was not the surprise to economists that Mr. Heath imagines.

The irony is that the ideology Mr. Heath follows is itself based on economics: economics as understood by a first year student who only listened to a third of their lectures. For Heath economics is fine as long as it is explaining the virtues of the market and competition, but if economists look at market imperfections then they are “obsessed”.

When I see Heath and his compatriots extol the virtues of the regulation free world that will be possible once they are freed from the shackles of the EU, I am reminded of the Troika and Greece. The Troika has been effectively running Greece for 6 years, yet unlike Ireland or Spain the economy remains in depression with no signs of hope. But rather than question what they have done, they blame the Greeks for not pursuing the prescribed policies rigorously enough. The UK is one of the least regulated OECD economies, and has recently had 6 years of government spending cuts and corporation tax cuts, but productivity growth since the crisis has been painfully slow. Rather than question the efficacy of the medicine, the ideologues blame the EU from preventing them doing even more.

It also reminds me of the Scottish referendum, where those in favour of independence just did not want to hear the bad news about the short term fiscal outlook. Some decided that those bringing that news were part of some Westminster conspiracy, and all preferred to believe the wishful predictions of the SNP. I’ll repeat now what I said then: do you really want to be ruled by people who prefer make believe stories to evidence, and who are so desperate for votes they tell you to ignore an entire academic discipline.