What not to do about the housing market
Monday 14 August 1995
Various measures are touted - tax breaks for those with negative equity, an increase in the value of mortgage interest tax relief, extra incentives for first-time buyers, the abolition of stamp duty on house purchase. Some combination of these measures, if implemented on a substantial scale and for a limited period, could probably achieve the aim of boosting house values and increasing turnover in the market. They could also be highly damaging.
A key point is that rising house prices do not represent an increase in the real wealth of the UK. If prices rise, for reasons unconnected with the physical quality of the housing stock, nothing real has changed. Just as the world as a whole is no richer when the price of gold goes up, so the UK, as a whole, is no better off when the price of houses rises. If we sold gold to beings on other planets and imported extra-terrestrial widgets, a rise in the price of gold would make us better off - but we do not. Neither do we export Victorian semi-detached homes to Europe.
The point is that every seller of a house needs a buyer. The more the seller gets the worse off is the buyer. A rise in the house price generates a gain to one party which is equal to the loss of the other. House price rises merely redistribute wealth to those with residential property who want to trade down from those who want to trade up.
The two most obvious groups of losers from house price rises are first- time buyers and those needing to move up the property chain as their families grow. It is unclear why these groups are more undeserving than those who benefit from house price rises, such as older people selling houses that have become too large for them.
There are other reasons to resist the pressure to boost the tax breaks on home ownership. For some time the tax treatment of owner-occupied housing has been highly favourable compared with the tax treatment of rented property. Home owners receive tax relief on a part of their mortgage interest payments, pay no tax on capital gains and are not taxed on the effective income they receive from the real benefits of home ownership. The latter can be thought of as the payments that would have to be paid if an owner occupier were to pay rent to him or herself. This income is untaxed, but people who rent pay it from taxed income.
A prime reason why the UK has one of the smallest private rented sectors - around 10 per cent of all properties - is the unfavourable tax treatment of rental property. The costs of having a small private rented sector - in terms of reduced labour mobility and limited choice - are hard to measure but may be substantial. Any new tax breaks on owner-occupied housing would increase these costs.
Furthermore, measures to boost housing turnover and prices may begin to feed through just when the market will be picking up anyway. They could thus fuel the next boom rather than just take us out of the current slump. This may seem fanciful but the experience of the housing market over the past 30 years shows that the switchback from broadly stable to rapidly rising house prices - and then back to falling prices - can be rapid and dramatic.
There are good economic reasons for the rollercoaster behaviour of the housing market. Big movements in the real cost of housing are likely to stem from shifts in interest rates and in the level, and expected rate of change, of house prices. Expectations of house price changes are likely to be volatile but they are also the single most important factor in affecting the demand for housing.
I have constructed a simple measure of the real cost of owner-occupied housing from two key factors. One is the level of real house prices. The other is an expected real interest rate, defined as the nominal interest rate less expected house price inflation. I assume people form expectations about future price changes by looking at average house price changes over the past three years.
The chart shows how the real cost of housing would evolve over the next few years if mortgage rates were to rise by 50 basis points over the rest of 1995 and then remain steady. I assume retail prices rise at 3 per cent a year and that real house prices rise from now on at their long-run average rate of 2.5 per cent. I also assume no tax changes.
On this basis, the real cost of housing would fall by almost half by 1998. Of course interest rates may rise more over the next few years so the decline in user cost may be more muted.
But more significant, though harder to gauge, is the potential for feedback from a lower real cost to higher demand and then to higher prices. This, in turn, would lower the real cost again as people adjust up their expectations of short-term capital gains, generating a further rise in demand. Clearly this process can easily become unstable, as it has done in the past. A hastily devised package of measures to boost demand could greatly exacerbate this inherent instability.
What is needed now is to give people the opportunity to protect themselves against the risk of sudden changes in house prices, not short-term measures that may boost the housing market but may also increase the weight of property in the total wealth of households.
For many home owners, the exposure to the sort of shocks that hit the housing market - such as unexpected interest rate changes, changes in job prospects, changes in the tax regime - is very high because these shocks affect their incomes and also hit the value of their biggest asset, the house. The things that have an adverse effect on incomes usually reduce house prices, thus decreasing the value of collateral against which to borrow just when home owners may need it most.
So home owners stand to gain in a big way if they could reduce the exposure of their wealth to shocks that hit local house prices. The scope for new types of financial contracts to help people hedge these risks could be enormous. Based on property prices, these contracts would be designed to generate net payments to home owners when the value of their homes turned out to be below some predetermined value and would involve some sharing of capital gains if prices rose fast.
Contracts of this type offer insurance against the risks of big swings in house values. Unlike moves to kick start the housing market with tax breaks, they address the real problems of home owners - and first-time buyers - in the UK.
David Miles is chief UK economist at Merrill Lynch.
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