WHAT have been the surprises so far this year? Globally, we’ve seen the further rise (and fall) of oil prices but continued strong global growth. The steam has come out of the US economy but America appears to be heading for a slowdown rather than anything more worrying.
In Britain, by contrast, the economy has had plenty of steam. At the start of the year the average prediction was for growth of 2.1% this year. Now it is 2.6%.
Alongside higher growth, however, there has also been higher inflation. In January economists expected consumer price inflation to end the year at 1.9%, below the Bank of England’s target. Now they expect 2.5%.
RPI (retail prices index) inflation is expected to end this year at 3.6%, much higher than the consensus expectation of 2.7% back in January.
Perhaps the biggest domestic change, however, has been in the housing market. Last winter housing was convalescing. Having slowed sharply in the middle of 2004, it did not appear likely to speed up again very soon. In the latter part of 2005, house-price inflation dipped below 2% on both the Halifax and Nationwide measures.
But housing was not dead, merely sleeping. Perhaps the Bank of England’s one-off interest-rate cut in August last year provided the elixir. Maybe, in London and southeast England at least, it was those City bonuses.
The latest figures from the Nationwide, which had house prices last month up by 8.2% on a year earlier, suggest London continued to lead the way in the third quarter, with the strongest rise of any English region. For true Klondike conditions, however, you had to look to Northern Ireland, with third-quarter prices up by 33% on a year earlier. We are more accustomed to housing booms south of the Irish border.
The effect of rising population and limited housing supply on prices should not be underestimated. The number of new “dwellings” being completed is rising. I use the word dwellings advisedly because about half of current “housing” starts are flats and maisonettes. The House Builders Federation has just changed its name to the Home Builders Federation for that reason.
In 2004-5, 206,750 dwellings were completed, nearly 9% up on the previous year. But housebuilding has not moved decisively higher. During the 1990s, the typical number of new dwellings completed was about 190,000. Nearly 90% of new accommodation these days is built by the private sector.
These are gross figures. When you convert a house into flats you gain the flats but lose the house. Kate Barker’s review of housing supply for the Treasury suggested that conversions and demolitions mean the loss of about 50,000 properties a year.
So net new housing is roughly 150,000 units a year, and the Barker review suggested we might need getting on for double that to slow house-price inflation decisively. Her review, it should be noted, was published in the spring of 2004, before the big influx of migrant workers from Poland and the other EU accession countries.
Housing demand is not, of course, just about population growth and immigration. It is also affected by size of household, divorce, how early young people fly from the parental nest, second homes and a range of other factors. The government’s projections show that in England alone there will be an average of 209,000 new households annually over the next two decades.
The strength of housing demand is one thing, but what about the “fact” that house prices are plainly too high? The surprise about this year’s housing market strength is that what looked like an overvalued asset has gone up a lot more. How can this be, and how dangerous is it? Perhaps not at all, because housing was not overvalued.
Professor Steve Nickell, then a member of the Bank of England’s monetary policy committee, set the ball rolling more than a year ago on this with his British Academy Keynes Lecture.
He cited three factors — low levels of housebuilding, low short-term interest rates and, most importantly, low long-term real (after-inflation) rates — and said: “It may be legitimately argued that there has been no housing bubble whatever.” Indeed, it could be argued on the basis of his analysis that prices were still undervalued. Sure enough, they began rising soon after his September 2005 speech.
Economists at Lombard Street Research have taken that process on, in particular the fact that housing valuations are highly sensitive to the level of interest rates, to develop a different kind of affordability index.
“The interest rate is by far the most important determinant of housing price affordability,” says the firm’s Diana Choyleva in its latest Economic Bulletin. “Examining various scenarios for house-price affordability, it becomes clear that if house-price inflation is subdued, then mortgage rates will have to increase to above 8% in order for the housing market to become a bubble.”
Whether it is a bubble or not, in other words, depends on the level of interest rates. If the Bank was forced to push up base rate to 8%, there would be a clear overvaluation. With a Bank rate of 5% there is not.
Lombard Street, indeed, thinks house prices will rise quite strongly next year, with prices up by more than 12% on the Nationwide measure and nearly 14% on the Halifax’s index, in spite of a rise in Bank rate to 5.25% early next year.
Whether or not prices rise so strongly, many readers will dispute Lombard’s starting-point, that houses are close to their average affordability level of the past four decades. How can this be when so many potential first-time buyers are locked out of the market? The answer, I think, is twofold. Existing homeowners have done extremely well in recent years and have been able to use their wealth gains to trade up. Buy-to-let landlords have, to a certain extent, moved in to make up the gap left by first-time buyers. Some first-time buyers, of course, continue to climb on to the first rung of the housing ladder, often with the help of deposits extracted from their parents’ wealth gains in property. But many do not, and there is no denying that rising house prices have created social problems.
When does the process come to an end? Not for a long time, according to the Lombard Street analysis. I would hope things settle down rather sooner. But that may require, among other things, that we build a lot more houses.
PS: Some people say economists have too much influence these days, but in some areas they do not have enough. Laws and regulations affect the economy enormously. All too often, however, their economic effect is misunderstood or miscalculated, as is pointed out in a new paper from the Institute of Economic Affairs — the Economics of Law by Cento Veljanovski.
Suppose you wanted to reduce property crime by 1% and had three options — increasing police numbers, sending more offenders to prison, or increasing the length of sentences. A politician would probably choose the extra police, as would most voters. But a classic piece of research, quoted by Veljanovski, shows that it would cost 10 times as much to do this as imprisoning more criminals, and 14 times as much as lengthening sentences. Food for thought at a time when the debate is about sending fewer people to prison and shorter sentences.
Most policy decisions, let alone changes in the law, are not subjected to even rudimentary cost-benefit analysis. Gordon Brown has prom- ised (again) to cut red tape by 25%. He should start by getting the govern- ment’s economists to run regulatory impact assessments — cost-benefit analyses — on existing regulations. Many would fail to pass muster.
