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.

The Costs of Debt Finance: Jonathan versus David

                Recently David Smith of the Sunday Times and Jonathan Portes of the National Institute had a blog-spat about what a debt financed public investment programme would actually cost. Jonathan suggested that as the current interest rate on UK government indexed linked (i.e. inflation adjusted) debt was only 0.5%, £30 billion worth of investment would only cost £150 million a year. This was something like the amount the Chancellor was aiming to raise by removing VAT loopholes, including the infamous pasty tax. David responded that the value of the index linked gilt would rise with inflation, so that cost should be allowed for on an annual basis, which amounts to using a nominal, not real, interest rate. Jonathan countered that the nominal interest rate, which would be paid on debt of fixed nominal value, was not appropriate, because inflation would steadily erode the real value of nominal debt. In terms if the debate, I think Jonathan is clearly right, but I want to use the opportunity of going a little further by considering intergenerational equity, which David mentions right at the end of his post.

                Now if you or I take out a loan, we do not just think about the interest we will have to pay on that loan. We also should think about how and when we have to pay that loan back. But governments appear different, because unlike people they can continue forever, so in theory any borrowing by a government never needs to be paid back. Indeed, most of the time governments honour the debt of their predecessors.  So if the debt is an index linked gilt, the government just has to pay £150 million at today’s prices on the debt forever more. True, the nominal value of that debt will be rising, but so will the nominal value of everything else, including VAT receipts. Jonathan is right: if we spread the real cost (or burden) of financing the public investment across all future generations equally, which we can, then it’s the real interest rate that matters.

                In fact we could go further still. If the number of people in the economy is increasing, or each individual’s real income is rising, then this £150 million becomes an ever smaller share of total real income. In that specific sense, the ‘burden’ on future generations is less than on the current generation. If we really want to equalise the burden in terms of a share of income across all generations, then we should not just take off the inflation rate from the nominal interest rate, we should take off the real growth rate as well. Let’s call this ‘r-g’ for short. Now at the moment UK real growth is about zero, so this would not make any difference to Jonathan’s numbers, but in other circumstances it would reduce the cost still further.

                Now what would happen if this growth adjusted interest rate, r-g, is actually zero. We then get what seems like a magical result. Rather than raise taxes each year by £150 million, we issue £150 million worth of new index linked debt each year. You might think that paying interest by borrowing more is the road to bankruptcy, because the debt gets larger and larger. But not as a share of national income: that debt ratio would be constant if r-g=0. So £30 billion of public investment, which is about 2% of GDP, turns out not to cost anyone anything! Another way of thinking about it is that if there was a last generation, that generation would have to pay back the full 2% of their GDP, but there will never be a last generation, because governments (and government debt) can go on forever. We really do get something for nothing.

                Now, on average, r-g is positive rather than zero, so we do not get this magical result. But r-g is normally a lot smaller than the nominal interest rate. So, in terms of the conventional way that economists do these calculations, using the nominal interest rate is clearly wrong.

However, if our main concern is intergenerational equity, then this conventional approach might be a mistake, depending on the nature of the public investment. It would only be fair to all generations if the investment has benefits which rise with GDP and last forever. In that case using r-g is appropriate. If the benefits do not rise with real GDP, then using just the real interest rate would make more sense. However the benefits of most types of investment do not last forever. Suppose that the project was a new hospital that lasts for 100 years, but then falls apart completely. Tax payers in 101 years time should not have to pay for this hospital, which will no longer exist. So our assumption that the debt will never be repaid is not a very fair one on future generations if the benefits of the investment do not last forever. It is also not fair that the generation in 100 years time has to pay back the entire loan. Instead, each generation should pay some combination of interest and repayment of capital.

                The easiest way of doing this is to assume the value of the investment depreciates at some annual rate. If the benefit of the project does not automatically increase with GDP, then the appropriate cost would be the real interest rate plus this depreciation rate. It is like paying back the part of the debt each year that corresponds to the depreciated capital. In this case the cost will be higher than the real interest rate, although there is no reason why it should equal to the nominal interest rate.

                Now all this assumes that intergenerational equity is our only concern. It should not be. It should be a factor - I do not believe we can assume that the current generation will always look after that problem for us - but not necessarily the overriding factor. In the current situation, public investment is useful because it reduces involuntary unemployment. Furthermore, DeLong and Summers have shown that because of hysteresis effects in this situation, increased government spending may not cost us anything at all in the long run, even if r>g. They looked at additional government consumption, but their argument will be even stronger for government investment because of the positive supply side effects of this investment. In short, this really is the time to increase public investment, both in the UK and US, and cutting it is a very foolish thing to do.