Crisis, What Crisis?
Conventional wisdom maintains that the bubble in UK home prices is due to inadequate supply. Conventional wisdom is wrong. Despite tough British planning laws, the shortage of housing across the country is not acute. Overvaluation is largely the result of ultra-low interest rates. London property prices have also been boosted by foreign capital inflows. Low interest rates may be with us for a while. Global capital flows, however, are prone to sudden reversals.
A search of Google Trends shows that public concern with a “UK housing crisis” has been steadily rising. Relative to income, house prices have never been as unaffordable as they are today – the ratio of average home 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 home prices would be seen once every 370 years. That looks pretty much like a bubble.
Is a shortage in new homes to blame for the high prices? At first glance it might appear so. Last year, housing completions in the United Kingdom rose to just over 150,000. That’s 30 percent less than the average number of housing units completed annually in the 1980s. The solution is simple, say the pundits: Britain needs more houses. Planning regulations should be relaxed. Politicians outbid each other promising to build more homes.
Yet if high home prices were really the result of shortages, more people would be squeezed under the same roof. In fact, as Professor Gordon Gemmill of the University of Warwick observed in a letter to the Financial Times last December, the supply of homes 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 home. Since the financial crisis, the average household size has risen very slightly to 2.3 persons.
Furthermore, if houses were in such short supply rents should have been rising relative to income. This hasn’t been the case. Including housing benefits, 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.
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 market price of land, it is to be observed, depends everywhere upon the ordinary rate of interest.” When interest rates fall, the Scottish author of “The Wealth of Nations” noted, land prices tend to rise.
Over the last 15 years, falling interest rates have reduced the cost of buying a house with borrowed money. Land and home prices have climbed, just as 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 percent, well below the long-run average of 35 percent, according to Halifax, the building society. This all suggests that Britain’s housing crisis is largely the consequence of the extreme affordability of mortgages.
This conclusion is confirmed by the behavior 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. Home prices in Vancouver climbed last year by 30 percent. Yet as in the UK, housing density hasn’t been increasing in the Canadian city.
What the Vancouver and London property markets have in common is that they attract large numbers of foreign buyers. Foreign purchases have reduced the supply of housing available to locals. They have also increased the supply of money into the real-estate market, pushing up home prices. This explains why those markets which have proved most attractive to foreigners – among them Vancouver, London, Sydney, San Francisco and Miami – have seen house 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 snapped 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 first decade of this century 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 $1 trillion. The inevitable bursting of China’s credit boom will be felt in real-estate markets 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 most vulnerable to the collapse of Chinese capital flows. When that happens, nobody will be blaming a shortage of available housing for the mess.