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. 

The IPPR Commission’s plan for a new economy

The final report of the IPPR’s Commission on Economic Justice is released today, with the full title of Prosperity and Justice: A Plan for a New Economy. [1] I was lucky enough to get an advance copy, and it is a very impressive document: very well researched and well argued. It is nothing less than a blueprint for a new progressive government. Of course there are some proposals I have doubts about, but it is sufficiently authoritative that in future anyone should ask of any progressive economic programme how does it relate to the recommendations of this report.

As far as my own area of monetary and fiscal policy is concerned, I’m not sure I have seen in one place as clear and comprehensive a summary of the lessons of the recent past and a better set of proposals for the future. I wrote about an early draft of this chapter in April, so I will be brief here. Their proposed fiscal rule separates current and investment spending, but suggests the ONS and OBR look to obtain a measure of spending that helps future generations that is better than the national accounts definition of public investment. They suggest a substantial increase in public investment, while current spending in constrained by a rolling five year target for balance. However they suggest that if interest rates are stuck at their lower bound, the focus of fiscal policy (current spending and taxes as well as investment) should be stimulus. Readers familiar with this blog will know this is very similar to the proposals in Portes and Wren-Lewis, 2015 and the Labour Party’s fiscal credibility rule.

For monetary policy they suggest ending the primacy of inflation, and adding underemployment and nominal income as primary targets. In addition, they suggest that QE involve creating money directly to expand the activities of a National Investment Bank (NIB) when a large macroeconomic stimulus is required. Note that, unlike a fleeting proposal by Corbyn, money creation to expand the NIB remains a call made by the independent Bank of England in a recession rather than by the NIB itself or anyone else. I would go further on the Bank’s mandate, but otherwise the IPPR’s proposals look eminently sensible.

The chapter on industrial policy seems sensible, with some ideas from Mazzucato (e.g. public sector led missions) clearly evident. Beside the NIB already mentioned, there is an emphasis on direct support rather than via the tax system (e.g. patent box) which often have large deadweight losses. They argue an industrial strategy should not just be about helping and adding to innovation clusters based around universities, but also in increasing productivity in what they call the ‘everyday economy’. In my view it is higher productivity and not greater union bargaining power that will raise real wages in a sustainable way, although in other areas a greater union presence can be helpful (see below).

For many one of the most interesting ideas - of course not new - is to end the shareholder model, and replace it with a stakeholders model where workers have an influence on the board and executive pay. It represents a move from a US to a more European model. While I find this argument fairly convincing, the idea under reforming the financial system that the Financial Policy Committee (FPC) of the Bank should target house price inflation is misconceived. What the economy needs is falling house prices, and once you make house prices a target the pressure will be to stop that happening.

The idea of a citizen’s (social) wealth fund is interesting, but I’m not sure a strong case for it is made here. Why should a government hold assets and issue debt, for example? If you want to redistribute wealth from the wealthy old to the poorer young, why not do so directly? On tax the proposal to combine income tax and national insurance seems sensible, as is the idea of a replacing bands with a formula based system (as in Germany). The same goes for a lifetime gifts tax to replace inheritance tax, and a land value tax.

There is so much else in the report, but let me end by talking about one issue: executive pay. There is a cute chart in the report that I reproduce below.

The report starts, quite rightly in my view, by emphasising the dangers of inequality. It also suggests that this cannot just be tackled ‘after the fact’ i.e. by tax and welfare measures. But will the stakeholder measures talked about above, or greater union influence, be enough to reverse runaway corporate pay? The rise of the share of the 1% starts with the advent of a neoliberal US and UK, and it has made the rest of us noticeably poorer. The report involves reversing many aspects of neoliberalism, but an interesting question is whether that is enough to achieve a decline in the 1% share, or whether other measures like higher top taxes are an essential part of doing that?

It is a fascinating report for anyone interested in a progressive economic policy. Do read it.

[1] This is a personal nostalgic footnote, which I am only writing because I could not easily see this information online. New Economy also happened to be the title of the IPPR’s journal in the early 1990s, which is now called Progressive Review. I remember it well because between 1993 and 1995/6 I wrote a number of articles for it based around simulations of the macroeconometric model I had developed with Julia Darby and John Ireland. The idea to do that came from IPPR’s Economic Director Dan Corry, with Gerry Holtham as overall Director at the time. Apart from members of the modelling team, Rebecca Driver helped write a number of the articles. The first article over that period had the title “What’s so Bad about Borrowing?” (plus ça change), and the last “Avoiding Fiscal Fudge” which proposed an independent fiscal institution or fiscal council for the UK. That took 14 years to come to fruition, and I hope many of the proposals in this report do not have to wait so long.

House prices and rents in the UK

I am not a housing expert, but it seems to me that the public debate is completely confused because it fails to make the distinction between house prices and rents. If we are talking about the supply and demand for housing, the price that equates those two things is rent, not house prices.

I discussed why here, but let me summarise the argument. Rent reflects the cost of being housed, of having a roof over your head. If there are less houses to go around, rents will be higher: higher enough to make some people share flats, live with parents or whatever. Because houses to buy can quickly change into houses to rent, there are not really separate markets for buying and renting, but just one big housing market.

The price of a house is the price of an asset. The asset in this case provides a roof over your head for as long as you own it. This means that house prices depend on current and future rents. Crucially, however, like any asset, the price is the discounted sum of future rents, where the discount rate is the real rate of interest. If real interest rates fall but future real rents stay unchanged, housing becomes a more attractive asset, and so wealthy people will buy more houses, pushing the price up.

Below is a chart of the ratio of house prices to rents in the UK and France, from OECD data.

There are large swings, but no major trend before around 2000. (That may surprise people, but it reflects what has happened to rents which we will come to.) In the early years of this millenium the house price to rent ratio increased substantially in both countries, and has stayed higher. I have included France with the UK to suggest that there may be some common factor influencing their similar behaviour. [1]

That common factor is real interest rates. You can define real interest rates many different ways: here I’m just going to be very lazy and pull data from the World Bank.

Again ignore the details (I have no idea about 1995) and focus on the trend. Around 2000, real interest rates started falling, and falling substantially. As real interest rates fall, house prices rise.

This will only be true if the housing market is liberalised so that this kind of arbitrage works, and that there are no taxes that stop the arbitrage happening. That was not the case in the UK before the 1980s (mortgages were rationed when I bought my first house), which is just one reason why you would not expect this relationship to hold over that period. But in the last two decades, lower returns on other assets has seen the rise of the middle class landlord as a way of saving for retirement.

This substantial fall in real interest rates is a worldwide phenomenon, and it goes by the name of secular stagnation. Why it has happened and to what extent it is permanent is still the subject of lively debate, which is beyond the scope of this post. The key test will be when nominal interest rates begin to rise over the next few years: to what extent do real interest rates rise with them. All I can say for sure is do not rely on those who say house prices always rise over time.

Thus the rise in house prices in the UK and France since 2000 has got little to do with a lack of house building, a point that Ian Mulheirn has stressed. But what about rents, which is where we should look for any imbalances in supply and demand. Here is some IFS data from a recent paper by Robert Joyce, Matthew Mitchell and Agnes Norris Keiller.

Outside London, there has not been a rise in the proportion of income spent on rent. Essentially, and I suspect this applies before the mid-90s, housing costs (rents) have risen with earnings rather than prices, and at constant real interest rates that would mean house prices rising with earnings. This represents a very reasonable return on any asset, and is why we think buying a house is a good investment. Now you could argue that we should build enough houses so that this proportion of income spent on housing falls, as it has for food for example. What you cannot argue is that building too few houses has anything to do with why houses have suddenly become unaffordable to young people.

The situation for rents has clearly been different in London in recent years, and London house prices have also risen much faster than elsewhere. David Miles and colleagues have written an interesting paper on how house prices in cities can rise as more people work in them but transport costs do not fall. In recent years UK governments have been trying to reduce the subsidy for train travel, and higher rents are a natural consequence. One way to reverse this is to invest in new and improved transport links into cities. However I think the main reason that house prices have recently risen in major cities in many countries is the decline in real interest rates noted above. (Here is the same debate in Vancouver.)

Does secular stagnation (low real interest rates) mean that a whole generation has to rent rather than buy? The main problem is the deposit that first time buyers have to find. Low real interest rates mean a mortgage is easier to service once you have one, although low rates of nominal earnings growth mean that it doesn't get so much easier over time as it used to. But rising prices means rising deposits, which if parents cannot help means saving for a long time. Banks do not want to take the risk of lower deposits, particularly if there is a real chance that house prices could fall. Help to Buy is about the state taking over the risk that Banks will not take, but is that something we collectively want to do? That is the debate we should be having in an age of secular stagnation. Building more houses may or may not be fine, but if real interest rates stay low it is not going to make houses affordable again for the generation that can no longer buy a home.

[1] It is fascinating to look at the countries that are similar to the UK and France, and those that are not (like the US and the Netherlands, but especially Germany). If anyone can tell me why these countries have not seen a permanent upward shift in house prices I would love to hear it.

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.

Why high house prices are partly down to austerity

Diane Coyle, in reviewing Rowan Moore’s book Slow Burn City: London in the 21st Century, focuses on the idea that forever rising house prices could gradually kill off what is now a vibrant city. As housing gets steadily more expensive, getting people to work there will get more and more difficult. In the meantime, young people who can afford to buy get more and more into debt. I wonder whether soon mortgage providers will become more interested in the wealth of borrowers parents than in the borrower’s own earning capacity. (This is not just a London problem: see here about New York for example.)

The reason for this that everyone focuses on, understandably, is stagnant housing supply. However, housing can also be seen as an asset. Just as low real interest rates boost the stock market because a given stream of expected future dividends looks more attractive, much the same is true of housing (where dividends become rents). Stock prices can rise because expected future profitability increases, but they can also rise because expected real interest rates fall. With housing increasingly used as an asset for the wealthy, or even as a way of saving for retirement, house prices will behave in a similar way. A shortage of housing supply relative to demand raises rents, but even if rents stayed the same falling expected real interest rates raise house prices because those rents become more valuable compared to the falling returns from alternative forms of wealth.

That is why a good part of the house price problem comes from the macroeconomy: not just current low real interest rates, but also low expected rates (secular stagnation). The idea that house prices are tied down by the ability of first time buyers to borrow (and therefore to real wages or productivity, modified by changes in the risks lenders were willing to take) seems appropriate to a world where the importance of the very wealthy was declining, and most people could imagine owning their own home. We now seem to be moving to a more traditional world (remember Piketty) where wealth is more dominant, and with low interest rates that may also be a world where renting rather than home ownership becomes the norm for those who are not wealthy and whose parents are not wealthy.

There may be factors behind secular stagnation (low long term real interest rates) that we can do little about, but there are things we can do right now that will raise interest rates, and thereby tend to lower house prices. The most important of those is to stop taking demand out of the economy through continuing fiscal consolidation (aka austerity). This boost to demand that comes from ending fiscal consolidation will allow central banks to raise interest rates more quickly. While central banks may only be able to influence real interest rates in the short term, because so much uncertainty exists about what this long term involves the short term may have a powerful influence on more distant expectations.

We can also have some positive influence on the longer term by increasing public investment, including forms of public spending (that may not be classified as investment) that encourage private investment. It should also include building houses where (or of a kind) the private sector will not build. That will have beneficial effects in terms of raising real interest rates in both the short and longer term.

Ever rising house prices lead to unprecedented high levels of private debt, and also destroy the dream of many young people to own their own home. One answer is to build more houses, but another is to run better macroeconomic policies. That house prices continue to rise during a period of fiscal austerity is not an anachronism. It is not a bug but a feature of an age of austerity.

House prices, rents, and supply

In a previous post I argued that high house prices, in the UK and perhaps elsewhere, could simply reflect lower expected long term interest rates. This had some people puzzled, because it appeared to ignore supply and demand. Surely it is higher demand combined with inelastic supply (supply that is insensitive to changes in prices) which is to blame for high house prices? This short post clarifies how both views can be correct at the same time. I also raise a question about housing wealth and inequality at the end.

The easiest way to think about this, at least for me, is to imagine no one owned their own home. Everyone rents, and houses are owned by landlords. Rents represent the price of ‘housing services’, which is the flow of benefits we get by having a roof over our head. If we calculate these rents in real terms, we have the relative price of housing services compared to other goods. Real rents will reflect the supply and demand for these housing services. If we all suddenly decided we wanted to rent a house in the countryside as well as our house in the city (or vice versa), and if the supply of houses did not increase, rents would rise dramatically until enough of us thought that maybe this wasn’t such a good idea after all.

Suppose real interest rates fall, but the supply of housing is fixed. There is no particular reason why lower real interest rates should change the demand for housing services relative to other goods. Then with no change in demand or supply, rents do not change in real terms. But house prices will, because they are - to use a bit of jargon - the present discounted value of future rents, where the discount rate is the real interest rate. This is a shorthand way of saying that lower interest rates mean that investments in financial assets yield lower returns than the same amount invested in housing, so investors will want to own houses rather than financial assets. This pushes up house prices until the rate of return on both types of asset are equalised.

That assumes housing supply is inelastic, which is a reasonable assumption in the short term. However suppose by some means (economic or political) these higher house prices generated an increase in the supply of houses to rent. If the demand for housing services is unchanged, greater supply will begin to push down rents. Falling rents push down the yield from owning housing assets. As a result, housing becomes less attractive as an asset, and prices begin to fall.

So if housing supply was very elastic, permanently lower real interest rates need not lead to higher house prices in the long run. Instead, they could produce much lower rents, because a lot more houses get built. Such an outcome seems unlikely in a country like the UK, but it could happen in a country like the US where there is plenty of land available to build on. This is one possible reason for the different trends in house prices in different countries that I commented on in my previous post.

So my original post was certainly not suggesting that increasing housing supply would have no impact on prices. What it was suggesting was that in evaluating whether current prices represent a bubble, we need to allow for the possibility that high prices today reflect a view that real interest rates may stay low for some time.

If interest rates do stay low for some time, and this does keep house prices high, an interesting question is why this matters. Take the case where everyone rents. Rents are unchanged, so those renting are no worse off. Landlords appear richer, but their future income in real terms has not changed. If people own their own houses, their houses have not suddenly got bigger or better. This is related to, but is not quite the same as, a question recently raised by Chris Dillow. It is different because it potentially applies to anyone who owns assets that get more valuable simply because interest rates fall, and not because the future incomes they generate increase. It is the same issue that is raised when some complain that Quantitative Easing, by - say - raising share prices, is benefiting the rich. I think this change in wealth does matter, as this evidence suggests, and I hope to explore the reasons why in a future post.