The Trouble with Bubbles
Copyright 2004 LMH News, issue 9, pp. 19.
Michaelmas 2004.
The recent performance of the British housing market has been quite astounding. Here in Oxford, I am part of a small group of economists who study the housing market (see www.housingoutlook.co.uk for details) and this article summarizes some of our research.
According to the Halifax, the average house price currently stands at about £160,000, almost exactly double the £82,000 it would have been worth at the turn of the millennium. Our research suggests that house prices have now surpassed their 1989 peak, relative to average household income. The other traditional measure of affordability, the ratio of mortgage payments to income, remains at reasonable levels, but only if capital repayments and unsecured debt are ignored. Many households are vulnerable to the increases in interest rates that have recently been announced and are expected later this year. Furthermore, the continued lack of demand among first-time buyers suggests that prices have become rather detached from their underpinnings.
Clearly we don't expect a rush of people selling their houses and moving into rented accommodation on the basis of our research. But it might well be worth remembering the repeated warnings from the Governor of Bank of England, Mervyn King, especially his wise words when asked for a headline by the Treasury Select Committee in March 2004:
'Think before you borrow, says boring banker'
To some extent the strength of the housing market reflects the excellent economic performance of the economy, which in turn is partly due to the sensible monetary policies pursued by the Bank, and partly due to Gordon Brown's expansion of public spending. As a result, Britain weathered the world economic slowdown of 2001-2003 much better than most major economies, chalking up six per cent growth, compared with a G7 average of four per cent, and only beaten by Canada.
But this robust growth can't fully explain the strength of the house price boom. Consequently, many economists have argued that there is a bubble in the British housing market, in common with a number of other countries (such as Spain, Australia, Canada, Sweden, and parts of the USA). Research by the Bank for International Settlements suggests that there is a historical link between peaks in equity markets and peaks in housing markets, with the latter tending to follow the former by about two years. This seems to occur for two reasons. First, the initial effect of a fall in share prices is to encourage investors to switch their savings into housing, and second, because stockmarket crashes tend to cause aggressive interest rate cuts that further stimulate the housing market. In Britain's case, the very public problems in the pensions' industry also made investors switch away from shares and towards housing.
So, while the Bank of England did a good job of maintaining economic growth, it was at the cost of an unbalanced economy. Our research suggests that the Bank was too relaxed about the housing bubble, and that comments by Monetary Policy Committee members were occasionally a little complacent. For example, both Kate Barker and Marion Bell have said that while the high level of house prices doesn't worry them, the Bank might act if prices began to fall and consequently had an impact on demand - this is dangerously close to saying that housing is a one-way bet.
But the mandate of the Bank is to target the measure of inflation chosen by the Chancellor, which explicitly does not include house prices, so it is probably too much to ask the Bank to control both consumer inflation and house prices at the same time.
The Chancellor has been looking at a number of possible means to stabilize the market, without having yet discovered a really good prospect. Initially he tried raising Stamp Duty but since this is a tax on transactions not on prices, it turned out to be quite a blunt instrument (a similar argument applies to Capital Gains Tax). Last year he commissioned reports from Kate Barker and David Miles on, respectively, how to increase the supply of new housing, and how to persuade people to take on fixed rate mortgages. Both reports made many useful suggestions, but made no definitive conclusions about future policy measures.
Our research suggests that there are two possible, complementary, solutions. The first is to make the housing market work a little bit more like other asset markets. When stockmarkets get a long way out of line, it is possible for investors to sell shares that they don't already own in anticipation of buying them back more cheaply later. This is known as 'short-selling', and although it sounds rather risky and speculative, it has been shown to help stabilize some markets. The problem with housing though, is that it is difficult to hold a 'short' position except by selling your own house and renting somewhere, which is quite a costly business. The rise of spread betting on the housing market shows that there is an appetite for such an investment opportunity, but is only a small step in the right direction.
The other real need is for some kind of automatic stabilizer that doesn't rely upon policy action. The only sensible candidate for such a stabilizer is an explicit property tax. Our research group has consistently pointed out the inadequacies of the Council Tax regime its replacement by an efficient property tax would be great at delivering a variety of good things: greater regional fiscal independence, more stable house prices, and also a better spread of economic activity across the country. Its greatest virtue would be that in periods of rising house prices, tax bills would rise automatically; in periods of falling prices, tax bills would fall automatically - stabilising the market and the economy.
Council Tax reform is a political hot potato and no political party has a coherent policy at the moment, but a sensible property tax offers the prospect of a much more stable housing market, which must surely be a vote-winner.
You can email me at Gavin.Cameron@economics.ox.ac.uk
Last updated: 15 September 2004.
