Diane Coyle: Local solutions needed for Britain's housing crisis

As people become better off, buying a home is one of the ways they choose to spend their money

Housing is sometimes seen as a very British obsession, and therefore a very unique problem for the UK's economic policy makers. It has certainly been a sensitive political issue all the way back to the post-war housing shortage, through Margaret Thatcher's right-to-buy policy up to today's assault on planning restrictions in London and the South-east.

With the annual rate of increase in house prices in the 20 to 30 per cent range, and the average price level above its 1989 peak in real terms, it's hard to escape Yogi Berra's sense of déjà vu all over again. Do such increases signal inflationary pressure that will eventually require a rise in interest rates at the expense of industry? Are home-owners getting into dangerous territory in terms of indebtedness? Do ludicrous house prices prevent the matching of workers to vacancies, especially in the over-heated South-east? In short, what can be done about this perpetual Achilles' heel of the UK economy?

One consolation may be that it is not in fact a peculiarly British problem. Rates of owner-occupation are high around the developed world, including the United States. As people become better off on average over time, buying a home is one of the ways they choose to spend their money.

As the first chart shows, real house prices display a long-term upward trend. In a small country such as Britain with a fairly static population, real house prices can be expected to increase at about the same rate as real GDP if demand for homes relative to other goods remains static, and a bit faster if that relative demand rises. So it proves. The long-term average rate of increase in real house prices in the UK has been a little higher than 2.5 per cent.

There have been other important changes affecting demand for home-buying over the more recent past. The second chart shows the ratio of households' mortgage debt to GDP rose in the late 1980s and has risen again recently. This reflects not only the two house price surges, in the late 80s and in the past few years, but also the liberalisation of mortgage regulations in the mid to late-1980s. Previously government rules had restricted many households to a lower level of mortgage debt than they wanted, and there has been an adjustment upwards. There is nothing in theory to tell us what the ideal level ought to be.

The transition to low inflation and low interest rates is also affecting home-buyers' willingness to borrow. The latest Bank of England Inflation Report points out that lower inflation reduces the burden of repaying a loan in its early years while increasing it in the later years, compared with a high-inflation world. The lower initial burden of debt servicing should raise both demand for and supply of mortgages, thanks to the lesser chance of cash-flow problems in the early years of the loan.

House prices are at their highest levels relative to average earnings since the late 1980s boom, but still well below those peaks. Real house prices are about 2 per cent higher than in mid-1989, but real average earnings are about 25 per cent higher.

What's more, affordability in terms of the monthly repayment on a typical loan relative to take-home earnings is very much improved compared with the 1980s and early 90s. On a £60,000 repayment loan, monthly payments amount to 35 per cent of disposable income now, down from 44 per cent in 1992 and more than 50 per cent in 1982.

Of course rapidly-rising house prices can contribute to inflationary pressure in the economy if owner-occupiers increase the rate at which they withdraw equity from their properties. It can be one of the sources of demand in the economy, which is why the Bank of England pays such close attention to the housing market.

That aside, though, it is hard to see why the housing market is thought to be so problematic – apart from one thing. The real trouble is that the existing homes are not always where people want to live so local mismatches occur very frequently – especially in big and growing cities subject to tough planning restrictions. In local markets supply might well be inadequate to meet demand. This is not a macroeconomic or inflationary problem, but it's none the less serious for that.

For example, a report newly published by the New York Federal Reserve notes that New York City's rental vacancy ratio is under 4 per cent, one of the nation's lowest along with Boston, Los Angeles and San Francisco. Over the 1990s the city gained some 120,000 new households but the city authorities issued only 81,000 certificates of occupancy for new housing units. London is by no means the only big city to worry about where to house its key workers.

However, potential solutions to this kind of problem will have to involve attempts to alter the supply-demand balance in local markets. Economy-wide measures will not solve it.

New York has tried to tackle its problems directly. On the supply side of the market, since 1987 the city authorities themselves have built 28,000 units for low-income families and refurbished another 155,000, moves which have helped ease affordability problems for low earners. In addition, tackling the demand side, a full three-quarters of renters in New York City either have their rents subsidised or regulated.

Building properties involves planning rows and high upfront costs, although these are subsequently recovered through rents or sales. Subsidising rents involves a permanent drain on the budget – a similar viable alternative for London would be a special London accommodation allowance for certain groups of workers. Controlling rents in private accommodation is cheap but unpopular with landlords and restricts the availability of rental properties.

None is cheap and easy to introduce. But these are the kinds of solutions that will be needed for Britain's real housing problem. We should waste much less time worrying obsessively about the lesser problem – or is it the thrill? – of double-digit increases in house prices.

Diane Coyle runs the consultancy Enlightenment Economics.

Diane@enlightenmenteconomics.com