Download Changes in the relationship between housing and the rest of the

Housing Research 122
August 1994
Changes in the relationships
between housing and the rest
of the economy
As a part of the Foundation’s major programme of research into housing and
the national economy, Geoff Meen of Reading University explores the nature
of interactions between housing and the rest of the economy using the Joseph
Rowntree Housing Model and shows how they have changed during the
eighties and nineties. These interactions have become more complex,
particularly since the mid eighties, and the failure to understand them has
been responsible for major policy errors over the last decade. In particular the
research finds:
The outlook for house prices and housing construction has become less
predictable since 1990 than was the case in the past. Traditional relationships
that were thought at best to require modification and at worst have broken
down.
There is little validity in the use of house price-to-income ratios as an
indicator of future price trends.
The responsiveness of new housing construction to changes in demand is
weak. This reinforces the volatility of house prices and means that house
prices can rise or fall more than general prices for extended periods.
Construction responds more to a fall in price than a rise.
Since the liberalisation of mortgage markets in the early eighties, the UK
economy has become more sensitive to changes in interest rates. Therefore,
the stance of monetary policy is of central importance to housing but it does
not follow that low interest rates are the answer for a healthy housing
market. Stability of monetary policy is even more critical.
Liberalisation of mortgage markets in the early eighties, in itself, had little
effect on house prices and consumers’ expenditure.
Differences in housing markets between the UK, on the one hand, and
Europe (particularly Germany and France), on the other hand, were major
contributory factors in the UK’s departure from the ERM.
Housing and
the economy
Housing and the macro-economy: are the
relationships unpredictable?
Changing housing market conditions have been
blamed for both the booming economy in the late
eighties and the subsequent slump. The fact that
economists both within government and outside
predicted neither reflected a basic lack of
understanding of the underlying relationships and
the role of housing in the economy.
Housing affects the wider economy in several
ways. Many empirical studies have shown that
changes in the market value of housing wealth have a
strong impact on consumers’ expenditure. Indeed, the
failure of government (and independent forecasters)
to predict the boom in consumers’ expenditure in the
mid to late eighties can be attributed, at least partly,
to the failure to understand the relationship at that
time.
But the interactions between housing and the
economy are more pervasive. Housing affects wage
settlements, regional migration decisions and the
overall growth rate of the economy.
Central to all these interactions are house prices
and construction. However, there is evidence that
predicting movements in future house prices and
housing construction has become inherently more
difficult since the slump in housing began. Welldefined relationships apparently explaining the
movements in both prices and construction can be
found for the sixties, seventies and eighties, which
would have failed to predict the severity of the
recession in the nineties. In particular they would
have suggested that the housing market would have
recovered more strongly and more quickly to the cuts
in mortgage interest rates that began in the Autumn
of 1990 (and saw rates fall from more than 15% to
around 8% at the current time).
Since interest rates have been a prime instrument
of demand management, the failure of markets to
respond is clearly of major concern to the
government.
There is evidence that the failure of markets to
respond is due to uncertainty. Householders have not
experienced sustained capital losses on housing since
the fifties and arrears and possessions have reached
unheard-of levels. We cannot rule out the possibility
that if the uncertainty is removed (and stable
monetary conditions are a crucial ingredient), then a
housing market boom could again take place.
Nevertheless, the message of this research is that we
should beware of precise predictions; the margins of
error are much greater than at any time in the last
thirty years.
The research also warns of the dangers of using
simplistic rules of thumb to predict future house price
trends. Many commentators use the ratio of house
prices-to-incomes as one such indicator. In fact there
is no evidence, either empirical or theoretical, to
support the use of such rules. Government policy can
easily change the relationship and indeed, the gradual
erosion of mortgage interest tax relief will in itself
have changed it.
The responsiveness of new housing
construction to demand changes is weak
There is a great deal of empirical evidence to suggest
that house prices respond strongly to changes in
housing demand. Quantitatively, the most important
factors are household incomes and interest rates. The
absence of a significant private rental market in the
UK increases the sensitivity of house prices to these
variables.
This lack of alternatives to owner-occupation
means that unless the supply of owner-occupied
housing can adapt quickly to changing demand
conditions, then house prices will inevitably be
volatile and will show much stronger changes than
overall prices in the economy. In fact, new housing
supply responds fairly weakly to changes in house
prices. There is some evidence that the response may
be weaker in the south east than elsewhere, but in no
English region is the response strong.
Construction will, however, respond more to a
fall in price than to a rise in price. This asymmetric
response is one reason why the recent recession in
construction has been so severe.
Both the lower price responsiveness in the south
east and the asymmetric responses suggest that the
planning system is a factor limiting the supply
response.
The United Kingdom and the ERM
Prior to joining the ERM, UK macro-economics policy
had been largely based on monetary policy. Fiscal
policy changes had been ruled out as a short-term
instrument, being aimed at providing the right
environment for a sustained growth of the supply-side
of the economy. But joining the ERM meant that the
UK no longer kept control over domestic monetary
policy. The requirement of keeping the pound within
bands implied that UK interest rates could not be
divorced from those of other countries, particularly
Germany.
But housing conditions in the UK and Germany
are very different. Owner-occupancy rates are only
42% in Germany compared with 67% in the UK;
households are less heavily indebted. Indeed the
UK is one of the most heavily indebted countries in
the world. The indebtedness of households implies
that (as discussed below) households will be more
sensitive to changes in monetary policy.
This is in contrast to Germany and France where
private consumption is not sensitive to changes in
interest rates - certainly much less sensitive than in
the highly geared UK. The relatively high level of
interest rates in Germany during the UK’s period of
ERM membership therefore meant that, in order to
sustain the exchange rate, interest rates in the UK
could not fall to the extent that would have been
required to support the UK domestic economy. At
least partly because of differences in housing and
housing finance markets, inevitable tensions within
the ERM arose, eventually leading to the UK’s
departure from the ERM in 1992.
The UK has become more sensitive to changes in
interest rates since financial liberalisation. This is
partly because of the rise in indebtedness, most of
which is held in the form of variable rate debt. But
this rise in indebtedness is, itself, a function of the
deregulation of financial (particularly mortgage)
markets in the early eighties. Prior to that time,
mortgages were for most periods rationed by one
means or another. Although there are good reasons
for deregulation, one implication that was not
appreciated then, was that deregulation would lead to
greater sensitivity to interest rate changes. Under
rationed conditions a rise in general interest rates did
not necessarily lead to a rise in the mortgage rate indeed for long periods during the sixties and
seventies, mortgage rates did not change at all. In
addition, even if mortgage interest rates did rise, the
fact that some households had previously been
rationed out of the housing market would cushion
the impact of the change.
The increasing sensitivity of the UK to interest
rate changes suggests that the conduct of monetary
policy since 1987 - an initial loosening of monetary
policy in an already strongly-growing economy,
followed by a reversal of policy in the following year,
was directly responsible for the sharp swings
experienced in housing markets in recent years. This
was also the fundamental cause of the escalation in
mortgage arrears and possessions.
However, interest rates have fallen from a peak of
more than 15% in 1990 to the current level of
approximately 8%. This is the lowest level since the
early seventies. This should have meant a much
stronger housing recovery than has in fact taken
place. It is now clear that cuts in mortgage rates, by
themselves, do not guarantee a recovery. A stable
monetary environment, rather than a low interest rate
environment is a prerequisite.
Financial deregulation had little effect on
consumers’ expenditure or house prices
It is commonplace to suggest that the deregulation of
financial markets led to the explosion in house prices
and consumer expenditure in the mid-eighties. This
is, in fact, a fallacy. Although deregulation certainly
created the scope for increased borrowing, it is
important to recognise that deregulation in the early
eighties was accompanied initially by the
maintenance of a tight monetary stance. It was not
until monetary policy was relaxed in the mid-eighties
that the boom began. Once again, the stance of
monetary policy becomes critical in a deregulated
climate.
Has the UK learnt its lesson?
Given events since 1990, it is tempting to conclude
that the UK will never again experience the booms in
house prices, that have taken place on three occasions
since the early seventies. Indeed, a case can be made.
Britain is now more committed to a low inflation
environment than at any time over the last twenty
years and if there is any sign of a boom, policy would
be quickly tightened. Second, arrears and possessions
are unlikely ever to return to the very low levels of the
early eighties. This increases the risks to housing as an
investment. Third, it is arguable that households will
have learnt from the experiences of the nineties and
will not be quick to rush back into owner-occupancy.
However, future booms cannot be ruled out. First,
survey evidence does not suggest that tenure
preferences have shifted significantly away from
owner-occupancy. Second, supply responses remain
weak in new construction. There have been no
attempts to change this so increased demand may
again be reflected in steep price rises. Third, substitutes
to owner-occupation remain severely restricted. The
private rental sector in the UK remains very weak in
comparison with countries such as Germany.
About the study
The study is based on analysis using the Joseph
Rowntree Housing Model and is part of a wider
programme of research into housing and the national
economy.
Further Information
The full report; Housing and the National Economy: Policy
and Performance in the Eighties and Early Nineties, is
published by the Centre for Housing Research and Urban
Studies, University of Glasgow. Further information can
also be obtained by contacting Geoff Meen, Department
of Economics, Faculty of Urban and Regional Studies,
University of Reading, PO Box 219, Whiteknights,
Reading RG6 2AW, Tel: 0734 875123, ext. 4079.
Related Findings
The following Housing Findings look at related issues:
79
90
92
95
101
109
119
120
Social housing investment and the 1992
Autumn Statement (March 93)
The state of the private rented sector (May 93)
Imbalances in the housing market (June 93)
Fiscal incentives to regenerate the private
sector (July 93)
The spread of negative equity (Dec 94)
The impact of higher rents (March 94)
Mortgage equity withdrawal: causes and
consequences (July 94)
Home owners in negative equity (July 94)
The following summaries are also relevant:
1. Private Renting after the BES
3. A Competitive UK Economy: The challenges for
housing policy
For further information on Findings,
call Sally Corrie on 0904 654328 (direct line for
publications queries only).
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York YO3 6LP
Tel: 0904 629241 Fax: 0904 620072
ISSN 0958-3084
The Joseph Rowntree Foundation is an independent, non-political
body which funds programmes of research and innovative
development in the fields of housing, social care and social policy.
It supports projects of potential value to policy-makers, decisiontakers and practitioners. It publishes the findings rapidly and
widely so that they can inform current debate and practice.