What not to do about the housing market

It is no great surprise that when an industry is depressed, those that depend on it for their livelihood lobby for something to be done. When the housing market is depressed, the number of people who feel significantly affected is enormous. With a low level of transactions and prices continuing to fall in many parts of the country - even after five years of declines in the real value of most homes - the pressure on the Government to "do something" is great.

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.

Arts and Entertainment
Gregg Wallace in Summer's Supermarket Secrets
tv All of this year's 15 contestants have now been named
Sport
The giant banner displayed by Legia Warsaw supporters last night
football Polish side was ejected from Champions League
Arts and Entertainment
Could we see Iain back in the Bake Off tent next week?
tv Contestant teased Newsnight viewers on potential reappearance
News
i100(and it's got nothing to do with the Great British Bake Off)
PROMOTED VIDEO
News
news It's not just the world that's a mess at the moment...
News
Angelina Jolie with her father Jon Voight
peopleAsked whether he was upset not to be invited, he responded by saying he was busy with the Emmy Awards
News
Bill Kerr has died aged 92
peopleBill Kerr appeared in Hancock’s Half Hour and later worked alongside Spike Milligan and Peter Sellers
Life and Style
A picture taken on January 12, 2011 shows sex shops at the Paris district of Pigalle.
news
Sport
footballPremiership preview: All the talking points ahead of this weekend's matches
News
Keira Knightley poses topless for a special September The Photographer's issue of Interview Magazine, out now
people
News
ebooksAn evocation of the conflict through the eyes of those who lived through it
Voices
The Ukip leader has consistently refused to be drawn on where he would mount an attempt to secure a parliamentary seat
voicesNigel Farage: Those who predicted we would lose momentum heading into the 2015 election are going to have to think again
Arts and Entertainment
Cara Delevingne made her acting debut in Anna Karenina in 2012
film Cara Delevingne 'in talks' to star in Zoolander sequel
News
i100
Sport
Mario Balotelli pictured in his Liverpool shirt for the first time
football
Life and Style
tech
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

SAS Business Analyst - Credit Risk - Retail Banking

£450 - £500 per day: Orgtel: SAS Business Analyst, London, Banking, Credit Ris...

Project Manager - Pensions

£32000 - £38000 Per Annum Bonus, Life Insurance + Other Benefits: Clearwater P...

KYC Analyst, Birmingham - £200-£250 p/d

£200 - £250 per day + competitive: Orgtel: KYC Analyst, Key Banking Client, Bi...

Test Manager - Banking - Yorkshire - £450 per day

£400 - £500 per day: Orgtel: Test Manager - Banking - West Yorkshire - £400-£5...

Day In a Page

Ukraine crisis: The phoney war is over as Russian troops and armour pour across the border

The phoney war is over

Russian troops and armour pour into Ukraine
Potatoes could be off the menu as crop pests threaten UK

Potatoes could be off the menu as crop pests threaten UK

The world’s entire food system is under attack - and Britain is most at risk, according to a new study
Gangnam smile: why the Chinese are flocking to South Korea to buy a new face

Gangnam smile: why the Chinese are flocking to South Korea to buy a new face

Seoul's plastic surgery industry is booming thanks to the popularity of the K-Pop look
From Mozart to Orson Welles: Creative geniuses who peaked too soon

Creative geniuses who peaked too soon

After the death of Sandy Wilson, 90, who wrote his only hit musical in his twenties, John Walsh wonders what it's like to peak too soon and go on to live a life more ordinary
Caught in the crossfire of a cyber Cold War

Caught in the crossfire of a cyber Cold War

Fears are mounting that Vladimir Putin has instructed hackers to target banks like JP Morgan
Salomé's feminine wiles have inspired writers, painters and musicians for 2,000 years

Salomé: A head for seduction

Salomé's feminine wiles have inspired writers, painters and musicians for 2,000 years. Now audiences can meet the Biblical femme fatale in two new stage and screen projects
From Bram Stoker to Stanley Kubrick, the British Library's latest exhibition celebrates all things Gothic

British Library celebrates all things Gothic

Forthcoming exhibition Terror and Wonder: The Gothic Imagination will be the UK's largest ever celebration of Gothic literature
The Hard Rock Café's owners are embroiled in a bitter legal dispute - but is the restaurant chain worth fighting for?

Is the Hard Rock Café worth fighting for?

The restaurant chain's owners are currently embroiled in a bitter legal dispute
Caribbean cuisine is becoming increasingly popular in the UK ... and there's more to it than jerk chicken at carnival

In search of Caribbean soul food

Caribbean cuisine is becoming increasingly popular in the UK ... and there's more to it than jerk chicken at carnival
11 best face powders

11 best face powders

Sweep away shiny skin with our pick of the best pressed and loose powder bases
England vs Norway: Roy Hodgson's hands tied by exploding top flight

Roy Hodgson's hands tied by exploding top flight

Lack of Englishmen at leading Premier League clubs leaves manager hamstrung
Angel Di Maria and Cristiano Ronaldo: A tale of two Manchester United No 7s

Di Maria and Ronaldo: A tale of two Manchester United No 7s

They both inherited the iconic shirt at Old Trafford, but the £59.7m new boy is joining a club in a very different state
Israel-Gaza conflict: No victory for Israel despite weeks of death and devastation

Robert Fisk: No victory for Israel despite weeks of devastation

Palestinians have won: they are still in Gaza, and Hamas is still there
Mary Beard writes character reference for Twitter troll who called her a 'slut'

Unlikely friends: Mary Beard and the troll who called her a ‘filthy old slut’

The Cambridge University classicist even wrote the student a character reference
America’s new apartheid: Prosperous white districts are choosing to break away from black cities and go it alone

America’s new apartheid

Prosperous white districts are choosing to break away from black cities and go it alone