A housing recovery would create new losers
Monday 24 July 1995
How do the links between the housing market and the rest of the economy really work? Obviously, a rise in house prices raises the real cost of acquiring extra housing services, so those households likely to increase their commitment to housing are clearly made worse off. Since these losses are offset by a gain for those who intend to reduce their exposure to housing in the future, the overall result is a large redistribution between generations. In simple terms, the old will gain from house price rises, while the young will lose.
Let us more formally split the population into only two age groups. The old are defined as the group likely to reduce its commitment to housing in the future, either by selling out completely, or by moving downmarket. The young are defined as the group which either has no property at present, or which is likely to move upmarket in future. How do both groups react when house prices rise relative to the prices of other goods and services?
First, on the surface, the old seem to have an obvious windfall gain to their immediate net worth, and they are quite likely to increase consumption as a result, relative to their incomes. In other words, they will probably save less. However, there is one question mark over this conclusion. Although the old themselves are better off, their heirs are actually worse off, since they will one day need to pay more for their housing. If the old are equally concerned about the welfare of themselves and their heirs, they will plan to increase the amount they bequeath to future generations, and this will offset the effects of higher house prices on the consumption of the old today.
Meanwhile, the young have the opposite forces operating on them. On the one hand, they need to save more to afford the same level of housing in the future, while on the other hand they expect to receive higher inheritances from their forebears, which will enable them to save less.
Overall, then, the theoretical effect of higher house prices on savings and consumption in the economy is unclear. In fact, if everyone is entirely rational about future inheritances, and if everyone fully cares about the welfare of all future generations, there should in theory be virtually no effect on overall consumption. This is because, in a long-run equilibrium, any gains today for the house-owning population would be exactly offset by losses for future generations.
However, in the real world, rising house prices are usually accompanied by rising consumption. This might happen because people in practice do not care as much about the welfare of future generations as they do about themselves, so they spend part of the windfall gains from higher house prices. Or it might happen because people are able to borrow against the rising value of their homes, thereby attaining access to the capital markets previously unavailable. For whatever reason, it is usually the case that higher house prices are associated with some increase in consumption relative to income.
Surely, this must be a good thing, one might think. Not so. An increase in spending relative to output would create inflation pressures in the system which would need to be offset by higher interest rates, or higher levels of taxation. Either way, a whole new class of losers would be created to offset the gains from higher house prices.
Alternatively - and this possibility raises some more complicated issues - the balance of payments might deteriorate as consumption rises relative to income. This would initially prevent any worsening in the inflation rate, but the key question would be whether this could be a permanent gain for UK living standards, or whether the deterioration in the trade balance would only be temporary. It would almost certainly be the latter.
Consider what would happen. The increase in consumption relative to income would automatically involve an increase in imports relative to exports, or a trade deficit. The offset to this would be a capital inflow from abroad, implying that foreigners would be lending more money to the UK than before. In the first instance, they might be willing to do this because they would accept the collateral implied by the increase in the value of UK housing assets. In other words, the UK would be financing its increased import bill by issuing claims on its housing assets.
But problems would soon arise. Foreigners would notice that the UK was not putting in place any new productive capacity which would enable the economy to service the build-up in foreign debt in the long run. Therefore, they would begin to notice that they were, in effect, providing goods for UK citizens to consume in exchange for claims on the housing stock in Britain. This would be acceptable to foreigners only if they believed that they could one day redeem these housing claims.
But the chances of them being able to do this would, in effect, be nil. Housing services are not capable of being sent overseas for foreigners to use, so the only way foreigners could redeem their claims would be, in effect, to "repossess" UK houses, sell them in the open market and take the money overseas. But this would inevitably depress the value of the housing stock, eliminating part of the "collateral" which foreigners believed they possessed. It would also reverse the initial gain in British consumption as house prices fell back towards their original level. The upshot of this is that any attempt by the UK to consume more as a result of a rise in the value of the housing stock would be quite quickly doomed to failure.
A case in point is what would have happened to the economy if house prices had in fact recovered sharply, as politicians were fervently praying, two years ago. One unequivocally good effect would have been that those families trapped in negative equity would have been freed up, and this would have increased labour mobility. But on top of this, consumers' expenditure would almost certainly have been much stronger, and this would have resulted in considerably greater inflationary pressure. Base rates would probably have risen by more than the 1.5 per cent, which we have actually seen, and this would have pushed the exchange rate higher. As a result, the remarkable improvement which has occurred in the balance of payments would never have happened.
I suppose it is far too much to ask, but I would applaud the first politician who has the nerve to say that a significant recovery in real house prices would be a very bad thing.
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