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.

November 2017 Budget: Tinkering rather than Transforming

The big story behind the November 2015 Budget is the absence of a big story. If our economy was doing very nicely with no major problems then minor measures here and there would be fine. In reality the opposite is true. In terms of average living standards, our economy is going through its biggest crisis of my lifetime. Forget about lost decades: annual pay in real terms is not expected to reach the pre-crisis peak until 2025. Productivity growth has been minimal since the low point of the recession eight years ago, and living standards have been further depressed by two large depreciations in Sterling. We now have an economy where growth is slowing, just when growth is picking up everywhere else.

The relevant question for this budget is what the Chancellor is doing about it. The answer, at least according to the OBR, is almost nothing. We know this because the OBR’s growth forecasts take account of all the Chancellor's measures in this and earlier budgets. So in spite of everything this government has said it has done to boost growth in this budget and beforehand, the OBR expect growth per capita to be less than 1%, compared to a steady average of 2.25% between the 1950s and the financial crisis. [1] All the Chancellor can claim is that growth would be even worse still if he had done nothing, or that the OBR has got it wrong.

In truth, though, he is doing almost nothing to boost growth. Rather than expand demand through fiscal expansion, as would be entirely appropriate given that interest rates are at or very near their lower bound and the Bank has been undertaking QE, he is continuing the erratic fiscal contradiction we have seen since 2010. There is a 1% contraction in the cyclically adjusted primary balance pencilled in over the next five years.

The most obvious tool that the Chancellor has to boost both demand and supply is public investment. With the cost of borrowing so low, almost every economist would argue we really should be seeing significant amounts spent on infrastructure investment financed by borrowing. After large cuts in 2010 and 2011, in the last few years we have seen public investment as a share of GDP increased marginally in each budget. In 2017/18 it is expected to be 2% of GDP, rising to 2.3% in 2022/23. This is similar to levels before the financial crisis, when the economy was in good health and the cost of government borrowing was much higher. In other words this level of public investment is totally inappropriate given the cost of borrowing and the extent of the macroeconomic nightmare we are living through.

But, surely, this is a budget for housing, that will finally help all those frustrated first time buyers get on the property ladder. That is what many of the papers tomorrow will claim. The OBR has estimated how many new first time buyers the cut in stamp duty will create: 3,500. As any economist will tell you, the main effect of this kind of measure is to raise house prices, benefiting existing house owners. So this Chancellor is continuing his predecessor’s habit of throwing public money at house owners to keep prices high. [2]

What about all these new houses? assuming they will be built. These would be welcome, but the impact over the next few years on house prices will be minimal given the size of the existing stock of houses. I would guess that a fiscal expansion that let interest rates rise significantly would do far more to bring house prices down, and much more quickly. (To see why, read this.) But then what Conservative Chancellor wants a large fall in house prices on his watch.

Of course there were some other welcome things in the budget, like more money for the NHS. But it is peanuts, and according to the Medical Director of NHS England it will not prevent already high waiting times rising further. The Chancellor is in effect telling those waiting even longer for operations that he is sorry but it was more important to spend £3 billion preparing for Brexit. 

What the Chancellor did not do is just as important as what he did do. This year's measures and previous plans continue to move money from the poor to the better off: cuts to tax thresholds and a freeze on fuel duty paid for by maintaining the cuts in work allowances for families that are part of Universal Credit, and freezes on other benefits. Another regressive budget from a Conservative Chancellor.

I have not mentioned anything about fiscal targets and fiddles to achieve them because it is these targets that helped get us into this mess and restrain this Chancellor for doing enough to make a difference. With demand, investment, the NHS and elsewhere, we can see how the Treasury view prevents the Chancellor taking action of the magnitude required by the scale of this crisis we face, a crisis made far worse by the stupidity of Brexit. Austerity lost us a decade, and Brexit looks set to make it two, but do not worry: the Chancellor is rearranging the deckchairs.

[1] There must be a strong suspicion that even this depressing OBR forecast may be too optimistic. The projections assume that the recent fall in the savings ratio is largely permanent (Chart 3.23). I would be rather surprised if that turns out to be true.

[2] If this was part of an attempt to replace stamp duty with higher taxes on housing wealth I would welcome it, but it is not.  

Brexit and the Left

There seem to be two strands of opinion which encourages people on the left to vote Leave. The first is an intense dislike of what has happened in the the Eurozone: see Larry Elliott for example. The second is a wish to take seriously working class concerns over immigration.

I share the intense dislike over what has happened in the Eurozone (EZ). You only need to read, for example, what I have written about Greece to see that. Yet I cannot see how UK exit from the EU will change for the good how the EZ works. Crucially why should it change the current politics of Germany that has been so important in many of the bad decisions the EZ has made. As we are not part of the EZ, it is difficult to see how UK exit will help its demise, if that is what you want.

As we will be leaving the EU and not the EZ, the message Brexit sends to Europe is not that the EZ is fundamentally flawed but rather that the UK is incapable of being part of any cooperative agreement among European countries. I am internationalist by nature so I do not want that. The idea that Brexit will shock the EZ into mending its ways, then thank us for showing them the light and invite us to rejoin whatever is left is pure fantasy.

There is one way the EZ crisis has impacted on the UK, and that is migration. It seems reasonable to assume that one reason immigration into the UK from the EU is currently high is because of considerable youth unemployment in many EZ countries. Which brings us to immigration concerns.

Take this from Kate Hoey for example. She seems to be arguing that free movement in the EU is a means of keeping down the wages of the low paid. The first point to make is if labour mobility keeps wages down in the destination country, it should increase wages and/or reduce unemployment in the country the migrant came from. As migrants move from lower to higher wage countries, then migration tends to equalise incomes. This should normally count as a plus from a left wing perspective.

But does migration have this effect on the receiving country? There are many reasons why it might not, and the evidence does not point to strong negative effects on wages. But I think the case for migration is stronger than that. A pretty robust finding is that migration at the kind of levels we are now seeing does not do any harm to GDP per head, and could improve it. Another robust finding is that current migration benefits the public finances. This is both important and pretty obvious..

Migrants tend to be young, healthy and working. They provide more in terms of resources than they take out by using public services. I remember having a conversation about this with someone who lived in Spain. He said if anyone should be angry about free movement it is Spain, in having to take lots non-productive British pensioners who will be a burden on Spain’s health service. This was also one reason why Merkel could be so open to refugees: Germany is really worried about the implications of their aging population. [1]

If migration falls following Brexit (a big if), and if we add in the other negative effects of Brexit, we will have a large increase in the government’s budget deficit even at full employment. Given government policy on how holes in the deficit are to be filled, this NIESR analysis suggests you are talking about large hits to the lower paid.

None of this is to deny real grievances about reduced public services and lower pay. Once again I do not think I and many others could be accused of keeping quiet about the stupidity of current austerity. But just as the grievances are real, it is also important to understand the real causes.

A consistent result in polls is that migration is a concern mainly in areas where there is little of it. In this poll only 19% of people say they believe immigration has had a negative effect on them personally. (More believe they have experienced positive effects.) Yet over 50% say it has had a negative impact on the NHS. In reality the NHS is in crisis because of government policy, not because of immigration. But to know that you need to talk to the experts and look at the figures. Instead most people will just have read the newspapers, many of which have taken every opportunity to play up the ‘threat’ of migration. As Paul Mason nicely puts it, you can tell this is a fake working class revolt from looking at those leading it.

This is part of a more general point on migration. Migration appears to be at worst neutral and probably beneficial for medium term UK prosperity, so if there are problems for some groups that can be fixed. At which point those on the left say that is naive because it will not happen. That is a reasonable point, but the same point applies in spades to the immediate aftermath of Brexit, which will amount to yet another shift to the right. The regulations that those running the Leave campaign want to ‘free’ us from are those protecting workers and the environment.

To make this clear, think of two realities (economists would call them states of the world). One (the status quo) involves those currently in charge remaining in charge. The second (left renaissance) involves left wing governments coming to power in the UK and elsewhere. It seems to me that if you stay in either one of these two realities, Brexit is clearly bad. (For a similar argument, see this by Alex Andreou.)

Under the status quo, the EU is currently a moderating influence on this right wing UK government. A post-Brexit Boris Johnson government would take away worker rights that the EU currently ensures and, as the deficit deteriorates, cut welfare benefits including tax credits. This alone will dwarf any benefit working people might get from less immigration. Under a left renaissance migration benefits the economy as a whole as well as those who migrate, and these gains could be fairly distributed. My feeling is that some Brexit supporters on the left move freely between these two realities in order to justify a vote for Brexit.

[1] One fair point made in comments on earlier posts is that migrants need to be housed, so resources are used to provide additional housing. (More generally new labour needs new capital of various kinds.) But housing also represents why migration can be beneficial to everyone. We need to build more houses anyway, but according to the industry we have an acute shortage of skilled construction workers. Of course this is an indictment of UK training programmes, but that cannot be turned around quickly. For those with construction skills, it is surely better to be building houses where they are really needed than being unemployed in places they are not.

Cutting public investment has consequences: house building

A post inspired by this from Alex Marsh

Here are two charts that tell their own story. The first comes from this site.

The second shows UK house prices from Nationwide.

Almost everyone agrees that UK house prices are currently much too high, and (partly thanks to you know who) getting higher. It is also clear that if you cut back on supply, but pressures on demand remain, prices will rise. In the first half of the 1980s, public sector house building effectively came to an end. Mrs Thatcher’s government did this, despite knowing that demand for housing was going to carry on increasing, as Ed Conway discovers (from the just released archives) in this post. In 1984 her housing minister advised against cuts on the scale actually made. Presumably Mrs Thatcher and her advisers hoped that the private sector or housing associations would fill the gap, but they did not, so prices started rising. [1]

Cutting back on public investment, and just hoping the private sector will increase their investment to compensate. Does that sound familiar? Cutting back on public investment, and paying for the consequences later. Does that sound familiar? Never mind, just keep repeating 'private sector good, public sector bad', and continue to get your facts from certain newspapers.

[1] Just to forestall an inevitable comment, the problem may well have been all those restrictive regulations we call planning, and the largely Conservative voting rural areas that use those regulations to resist new housing. (Or maybe it’s a bit more complicated, as Alex Marsh suggests.) But as every economist knows, if you remove one ‘distortion’ (public house building) while leaving others in place (planning), you can end up worse off, which seems to be what has happened.