House prices: supply is not the problem

Public concern with the UK housing crisis continues to grow. House prices have never been so unaffordable relative to income as they are today – the ratio of average house prices to median incomes in England and Wales is nearly three standard deviations above its long-run mean. In a normal world, the current level of house prices would be seen once every 370 years. That looks pretty much like a bubble.

Is a shortage in new houses to blame for the high house prices? At first glance it might appear so. Last year, housing completions in the United Kingdom rose to just over 150,000. That’s still 30% less than the average number of housing units completed annually in the 1980s.

The solution is simple, say the pundits. We need more houses. Planning regulations should be relaxed. Politicians outbid each other promising to build more houses. Yet if high house prices were really the result of shortages, we’d expect to find more people squeezed under the same roof. In fact, the supply of houses has risen faster than the population in recent decades.

As a result, the average size of UK households declined every year between 1981 and 2008 – from 2.65 to 2.29 persons per household. Since the financial crisis, the average household size has risen very slightly to 2.3 persons.

Furthermore, if houses were in short supply rents should have been rising relative to income. This hasn’t happened. If one includes housing benefit, the share of disposable income paid by private renters in England fell slightly between 2003 and 2013, according to the English Housing Survey. Excluding benefits, rents rose marginally relative to incomes.

The role of interest rates

A better explanation for high house prices is that interest rates are incredibly low. The link between real-estate prices and the cost of borrowing, often ignored by modern academic economists, was well known to the father of their discipline. In 1776, Adam Smith wrote that “the ordinary [ie, average] market price of land, it is to be observed, depends everywhere upon the ordinary rate of interest”. When interest rates fall, the author of The Wealth of Nations noted, land prices tend to rise.

Over the last decade and a half, falling interest rates have reduced the cost of buying a house with borrowed money. Land and house prices have climbed as a result,  just as Adam Smith would have predicted. The cost of mortgage repayments as a share of disposable income in the first quarter of this year stood at 30.5%, well below the long-run average of 35%, according to the Halifax building society.

In short, Britain’s “housing crisis” appears to be the consequence of the extreme affordability of mortgages.  This conclusion is confirmed by the behaviour of other housing markets around the world, where interest rates are also at abnormally low levels. In Sweden, where the central bank has been toying with negative interest rates, house prices have lately been rising at a double-digit pace. House prices in Vancouver climbed last year by 30%.  Yet as in the UK, housing density hasn’t been increasing in this Canadian city.

Foreign influence

What the Vancouver and London property markets have in common is that they attract large numbers of foreign buyers. Foreign house purchases have reduced the supply of housing available to locals. They have also increased the supply of money into the housing market, pushing up prices. This explains why those real-estate markets that have proved most attractive to foreigners – among them Vancouver, London, Sydney, San Francisco and Miami – have seen prices appreciating much faster than the average of their national markets.

Since capital controls were deregulated  in the 1980s, economists have observed the emergence of a “global real-estate cycle”. In the late 1980s, this cycle  was driven by the Japanese, who bought up trophy buildings in New York and beachfront properties in Hawaii.  The collapse of Japanese capital flows  in 1990 coincided with a global property downturn. The great Irish and Spanish property bubbles of the last decade were also popped by the reversal of global capital flows during the American subprime crisis. China has replaced Japan as the great fount of global capital.

Last year, China experienced abnormally large capital outflows, estimated at more than $1trn. When China’s credit boom bursts, the impact will be felt in real estate around the world. The countries with some of the hottest housing markets today – such as Britain, Canada and Australia – have large current-account deficits and are thus most vulnerable to the collapse of Chinese capital flows.

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