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Title: UK House Prices, Consumption and GDP in a Global Context


1
UK House Prices, Consumption and GDP in a Global
Context
  • Andrew Farlow
  • University of Oxford
  • Department of Economics, and Oriel College
  • John D Wood Co.,
  • The Cavalry and Guards Club, Piccadilly,
  • London, 20 January 2005
  • This is based on a paper to be found at
  • http//www.economics.ox.ac.uk/members/andrew.farlo
    w
  • (Syntax slightly improved post-presentation to
    make the slides more easily readable given the
    lack of a presenter)

2
Todays Presentation Part Three of Five Parts
  • Part One UK House Prices A Critical
    Assessment
  • Part Two Bubbles and Buyers
  • Part Three UK House Prices, Consumption and GDP
    in a Global Context
  • Part Four Risk Premia and House Prices
  • Part Five Mortgage Banks and House Prices
  • Book February/March 2006, Publisher Constable
    Robinson

3
UK historically strong housing cycles
  • Strong housing market cycles, linked to volatile
    consumption, have been an overriding feature of
    the UK economy for over three decades.
  • OECD (2004) 1971-2002, UK the strongest
    correlation of housing wealth and GDP of any
    country surveyed.
  • IMF(2004) The UK (along with Finland, Ireland,
    and Switzerland) has had one of the most
    procyclical housing markets in the world.

4
Something more global this time?
  • Something extra this time The first global
    house price bubble (The Economist)?
  • Small probability large loss events matter.
  • Even if only a small chance, we should analyze
    the possibility.
  • IMF, 2003 World Economic Outlook, 40 of booms
    followed by busts, and 8 cumulative GDP loss.
  • State of housing markets, part of a bigger
    picture of global imbalances?

5
UK House price falls and GDP falls
  • No fall in real house prices (blue line) not
    followed by major fall in UK GDP (gray bands)
  • Will the pattern repeat?

Source Bank of England Inflation Report,
May 2004, p7, Chart 1.10.
6
Consumption and House Prices
  • 1970-mid 1990s, rapid increase in house prices
    (green line) accompanied by rapid growth of
    consumption (red line)
  • Recently, house price inflation has accelerated
    but the rate of growth of consumption has
    steadied.

Source Bank of England Inflation Report May
2004, p12, Chart 2.1.
7
A breakdown?
  • Misleading causation.
  • Both driven by income expectations? Not directly
    observable.
  • Credit constraints?
  • A very different central bank response next time?

8
More evidence durables and non-durables
  • Real durable and semi-durables consumption is
    highly pro-cyclical.
  • But need to adjust for rapid price falls

Source Bank of England Quarterly Bulletin,
Spring 2004, J Power, Chart 1.
9
Nominal ratio of durable to non-durable
consumption
Source Bank of England Quarterly Bulletin
Spring 2004, J Power, Chart 11.
10
Real house prices and share of durable spending
in consumption
  • Durables more likely purchased on credit.
  • Share previously very correlated with house
    prices.
  • Correlation has broken down since the late 1990s.

Source Bank of England Inflation Report November
2004
11
More Evidence
  • Swings in spending relative to income in all
    periods - of homeowners is nearly as great as
    renters.
  • But risk premia and options thinking of owners,
    etc.

Source BOE Inflation Report May 2004, p12, Chart
2.3, based on the Family Expenditure Survey.
12
Possibilities
  • Credit constraints less important?
  • No upwards revision in expected future earnings
    and wealth?
  • This would have driven higher housing demand (and
    house prices) and higher desired stock of
    durables.
  • Flow increase in durables expenditure on the path
    to new desired stock level.

13
Awkward Conclusions
  • If real income expectations are pretty stable,
    how could these have driven house prices so much
    higher?
  • Not enough ability of demographic factors and the
    slow rate of house build to explain house price
    rises.
  • Great deal of weight placed on a credit
    constraint story for house price rises.
  • But difficult to create a consistent story if
    credit constraints are highly important for
    housing consumption but not for non-housing
    consumption, especially durables.

14
Or
  • Very high real house prices (and/or low interest
    rates) are not regarded as long-term sustainable
    by the general public?
  • Also some distributional issues since rapidly
    rising house prices (relatively) redistribute
    wealth from asset-poor to already asset-rich,
    from young to old. And this feeds subtle
    differences in aggregate consumption behaviour.

15
Mortgage Equity Withdrawal
  • 0 of household income in the late 1990s
  • Now over 8 today
  • Yet, consumption as a percent of household
    disposable income has hardly changed (1997-today)
  • What if MEW were to collapse this time?

Source Bank of England Inflation Report May
2004, p 13, Chart 2.4.
16
Correlation between annual house price inflation
and annual consumption growth
Source Bank of England Inflation Report
November 2004, p12 Chart B.
  • 10 year rolling correlation coefficient has
    collapsed

17
Need to correct for
  • Demutualisation of building societies. Windfall
    payments (fungible with MEW) of 35 billion, or
    7 of annual consumption, helped the jump from
    90 to 96 in two years with hardly any change in
    MEW.
  • Introduction of self-assessment.
  • The relationship is still weaker than in the past
    but nevertheless is more positive than it first
    appears.

18
The big consumption story?
  • Levels v. stocks The surge in the level of
    consumption from 86 to 96 of household
    disposable income created high rates of growth of
    consumption in the 1980s.
  • Recent consumption has run consistently at a much
    higher level for much of the last 7-8 years (with
    3-5 consumption growth per year).
  • The big consumption story of the late 1990s and
    early 2000s is the historically high level of
    consumption from disposable income, low levels of
    savings, and deteriorating pension provision.

19
More on MEW
  • Insignificant in the UK up to 1980.
  • 1980s liberalization.
  • No other country in the EU ever managed anywhere
    near to 8.
  • 1979-1999 Germany, France, and Italy net
    injection of 6 of household income into housing.

Source Bank of England, Office for National
Statistics and HM Treasury calculations. Chart
5.5, HMT 2004 p52, not updated.
20
Key MEW findings
  • 50-60 is last-time sellers and those trading
    down, i.e. those most likely to pay off debt and
    save.
  • A large proportion that is spent goes on home
    improvement and new goods for the home.
  • But, house prices and MEW are partly endogenous
    to any price bubble (family transfers, home
    improvement).
  • Borrowers who withdraw to spend are concentrated
    at higher incomes, but a sizeable proportion are
    on low incomes, and their borrowings are
    relatively high-level.
  • Low levels of serial remortgaging.

21
MEW and housing market Transactions
  • UK has one of the highest rates of housing market
    transaction in the EU.
  • Transactions volumes matter if most current MEW
    is released through last-time sales and trading
    down.

Source HMT Table 5.4, p51. Source Bank of
England and Office for National Statistics.
22
MEW cont.
  • MEW is more lumpy than many credit constraint
    stories suggest, which is why so much MEW is
    immediately saved and then generates a later
    flow.
  • Much of the consumption flow from recent MEW is
    still to come. More stabilizing?
  • If MEW plummets, there is no new flow into the
    stock of assets to generate new consumption flow.
    Less stabilizing?
  • In turning, or stagnant, housing markets price
    does not fall heavily at first transactions do.
    The liquidity of the market and ability to
    release equity falls.Those wanting to
    trade-down are heavily dependent on chains of
    buyers. Their ability to release MEW falls.

23
But
  • Only element of MEW that seems not cyclical is
    remortgaging (but evidence is hard to interpret).
  • For those forms of MEW that involve
    borrowingdebt bites much more in a low inflation
    environment.
  • What if those borrowing on MEW are excessively
    buying into the house price rise?
  • If MEW replaces more expensive forms of
    debtthis dries up if house prices fall.
  • A small consumption response can still be
    magnified by a big collapse in MEW.
  • If prices fall, there will be a collapse in MEW.

24
Demographics of MEW
  • Withdrawal of equity by last-time sellers is much
    greater than injection by first-time sellers.
    Stock of debt naturally rises over time.
  • If house prices are overvalued, those at the top
    have been removing more equity than they would
    have done in a less overvalued market, leaving
    behind on average more indebted households.
  • Price bubbles are highly redistributive.
  • Price bubbles are popular with voters, and
    politicians.
  • Element of being a Ponzi game.

25
MEW is not the main storySavings and pensions
are!
  • State of the housing market, level of savings,
    and pensions crisis are linked.
  • Global liquidity story too.
  • If consumers believe that rapidly rising prices
    are sustainablethen they may believe that
    current consumption can be run at very much
    higher levels than in the past.
  • Shocking evidence of unrealistic price
    expectations.
  • (Case, K.E., Quigley, M., and Shiller, R.J. 2004)
  • Slack taken from other parts of the household
    balance sheet, and over-reliance on housing to
    generate future pensions provision.

26
What about non-MEW
  • If many of those withdrawing housing equity are
    not immediately spending, what are non-MEW
    consumers doing to maintain consumption
    consistently at 96 or more of income?
  • Low savings
  • Eating into pensions contributions they should
    be making
  • Non-MEW forms of debt
  • Relying on house prices? Some notion of asset
    value allusion. Housing wealth fungible with
    other forms of savings? The cheapest form of
    credit?

27
Saving ratio
  • Shows UK households saving ratio and house
    prices (plotted with negative of saving ratio)
  • Paradox of thrift too in a major correction.

Source HMT 2004, Chart 6.3. p. 60. Source
Office for National Statistics and Office of the
Deputy Prime Minister.
28
Saving ratio cont.
  • Correlation between saving ratio and house price
    inflation one period earlier

Source HM Treasury, 2004, p64.
29
Impact of interest rates on house prices and
consumption
  • EITHER house prices are less volatile than in the
    past
  • OR, if they are still just as volatile, the links
    to consumption are weaker
  • OR, interest rates can cope with any problems
    (ease cash-flow problems, cushion/slow house
    price falls, etc.)
  • Direct and Indirect effects of interest rate
    changes via housing market
  • both have forces working for and against
  • Both are difficult to be precise.

30
Conclusions on direct and indirect effect
  • The direct effect of reducing interest rates
    after the last house price crash was large.
    Likely more modest today.
  • The Bank of England should worry less this time
    when raising (or holding high) interest rates,
    but also feel less confident of the power of rate
    cuts to make a big impact on aggregate cash-flow.
  • Indirect effect stronger, but not much interest
    rates can do if large speculative aspect to house
    prices.
  • But many caveats, including
  • Distribution and fragility of debt is not fully
    clear. Caution
  • Credit conditions generally
  • Dangers of moral hazard if perceived to be
    bailing out.

31
Redistribution effects of falling/rising house
prices
  • Rapid house price rises have similar consequences
    to sustained budget deficits, depressing the
    current real productive capital stock in exchange
    for current consumption by the gainers.
  • House price booms, just like government budget
    deficits, are popular with older consumers (and
    younger bubble-motivated consumer who know no
    better, or suffer asset price allusion).
  • Like deficits, older consumers benefit from the
    borrowing from future generations, even as
    long-term income levels are reduced due to the
    crowding out of real productive capital stock.

32
Distributional issues suppressing long-run values
  • Depressing influences on the investment potential
    of housing of the current generation (since the
    market for the value of their homes is the next,
    smaller, more burdened generation) include
  • demographically aging population
  • falling cohorts in younger generations
  • record low savings
  • deteriorating provision for retirement
  • the burden of social security and health
    increasing over time.

33
Still overvalued
  • This and other analysis (risk premia, etc.)
    suggests the market is still overvalued.
  • Given current overvaluation, the real rate of
    return on housing for, say, the next 20 years is
    much lower than the historical average of about
    2.5 (indeed, zero is within the 95 confidence
    interval for the 20 year real rate of return).
  • It also suggests that if correction is
    inevitable, it is not obvious that correction
    should be resisted.

34
Global House price correlations and global
liquidity
  • Highly synchronized positive movements in house
    prices, and global build up in mortgage debt.
  • An extremely recent phenomenon that does not
    affect all countries equally
  • US, Australia, UK, China, France, Ireland, New
    Zealand, South Africa
  • Relatively few EU countries.
  • The correlation between real house prices and
    output (and consumption) has declined since the
    mid-1990s, reaching unprecedented low levels by
    2003.
  • Potential for instability from outside UK
  • Hence issues of timing, interest rate decisions,
    etc.

35
Variance decomposition of house prices
Source IMF 2004, data
from Haver Analytics IMF, International
Financial Statistics national sources
OECD and IMF staff calculations.
36
UK case
  • House Factor and Global Factor over time, per
    cent change, constant prices, demeaned

Source IMF 2004, data from Haver
Analytics IMF, International Financial
Statistics national sources OECD
and IMF staff calculations.
37
UK decomposition of house price change over time
  • Orange Actual
  • Blue Global Housing Factor
  • Red Global Factor
  • Black Country Factor



Source Extracted from IMF 2004
38
Global Liquidity
  • Global driving forces especially US house
    prices, US interest rates, and global liquidity.
  • 25 per year growth in the sum of Americas cash
    and banks reserves held at the Fed, and in the
    foreign reserve holdings of central banks around
    the world.
  • Excess liquidity in the past flowed into
    traditional measures of inflation (goods and
    service prices).
  • Does extreme liquidity show up in asset price
    inflation house prices and record high global
    levels of debt, especially mortgage debt?
    Overreaction after stock market crash?
  • US housing stock has risen in paper value by 5
    trillion, almost precisely matching the
    5trillion of lost stock market wealth of the
    early 2000s.

39
Did Global interest rates go too low?
  • Natural rate of interest the rate at which the
    supply of savings of households exactly balances
    the demand for funds by firms for investment
    purposes.
  • Natural rate is roughly equal to the rate of
    inflation plus the real trend rate of growth.
  • Natural rate moves about according to
  • technological improvement
  • changes in preferences
  • the impact of demographics on the need for
    savings, etc.
  • If cost of capital set below this, get
    overcapitalization, the level of borrowing and
    investment will be excessive, saving too low, and
    the chances of bubbles greater.

40
Natural rate too low, continued
  • For UK about 5 (2 inflation plus 2 to 3).
  • Global natural rate (difficult to work out
    precisely) may even have risen (China, IT, global
    integration, inflation success, etc.).
  • Yet, some of these forces have also lowered
    inflation and even encouraged lower interest
    rates.
  • And bubbles encourage households not to save,
    making things worse.
  • Low rates followed collapse of late 1990s and
    various other crises/collapsing bubbles.

41
The US
  • US (especially) interest rate kept below natural
    rate for too long? 3 to 5 too low? Maybe after
    previous bubbles? Went from 6.5 in 2001 to 1 in
    2003.
  • Past five years Americas national spending has
    exceeded its income by about a fifth.
  • Private debt has boomed (nearly 10trillion).
  • Savings have hit 0.5 (compared to historical
    average of 8). Sometime, a reversion back to 8?
  • Private debt service is historically high even
    before interest rates rise.

42
US cont.
  • US government has joined US citizens. Approx
    450bn budget deficit per year.
  • Externally held portion of debt risen from 20 to
    45.
  • Problems with depth of US mortgage markets.
  • Problems with US lender of last resort.

43
US cont.
  • If a country has strongly favourable investment
    opportunities that will ultimately make its
    inhabitants much better off it is economically
    rational to consume some of the fruits now,
    borrow from the rest of the world, and repay from
    higher output later.
  • Meanwhile, run a strong currency and high trade
    and current account deficits that generate a net
    capital flow equal to the current account
    deficit. 
  • However, decomposition of US data shows that debt
    is currently largely being used to finance public
    and private consumption, rather than investment.

44
Asia and US mutually reinforce
  • Global foreign exchange reserves have doubled
    since the Asian crisis of 1998, to 3,800bn, with
    two-thirds of this in dollars. Asia accounts for
    80 of this growth and now has 70 of global
    reserves.
  • Reserves account for 9 of global gross domestic
    product, compared to less than 2 during the
    pre-1971 Bretton Woods era.
  • High demand for US debt may be a response to
    previous crises. It has chipped 0.5 to 1 off US
    yields. It has helped the US to run large
    government and trade deficits.
  • China has chipped 0.1 to 0.3 of US inflation
    (maybe as much as 1).
  • In turn, Chinas boom has been helped by low US
    rates.

45
House price contagion?
  • If sufficiently strong house price falls in one
    country (for example, rebalancing in the US will
    require lower spending on housing consumption) or
    several countries generate a decline in
    consumption for them, then it is more likely that
    consumption will fall in other countries too
  • Real contagion (via consumption).
  • Financial contagion (via, in particular, mortgage
    bank and government balance sheets).
  • Equity-based bubbles less damaging than
    debt-based bubbles. Has mitigating the first, led
    to the latter?
  • See Farlow, UK House Prices, Consumption, and
    GDP in a Global Context, Section 6, for
    scenarios for correction.

46
Impact on UK policy
  • How do these possibilities affect our attitude to
    falling house prices in the UK and central bank
    policy on interest rates?
  • If rebalancing of the UK housing market is
    inevitable, this suggests allowing rebalancing to
    proceed sooner rather than later leaving the
    housing market in a better position to withstand
    global disturbances consequent on rebalancing
    elsewhere.
  • Reversion to fundamentals, while it harms
    consumption, at least conceivably puts the
    economy back on a footing that emphasizes real
    economic activity over speculative housing
    activity and ends the distortions that lead to
    long-term pension and saving misallocation.

47
Lessons for the UK
  • Global instability might matter more for UK house
    prices than is perhaps currently accepted. The
    fate of the UK housing market may currently be
    one of the less domestically controllable aspects
    of UK macroeconomics.
  • The Bank of England has faced an unenviable
    choice between trying to turn the tide of house
    prices and not sacrificing growth and risking
    under-hitting its inflation target.
  • Emphasis on controlling the housing market has to
    include reforms and not just rely on interest
    rates.

48
Lessons for UK cont.
  • Interest rates may have little power to influence
    house prices in a price collapse anyway. Trying
    to generate a cash-flow affect to offset a
    wealth effect caused by an unwinding bubble may
    simply not work very well.
  • Handling global surges in house prices might need
    more of a coordinated response than it probably
    gets, or is ever likely to get.
  • Stop-go cycle via house prices in place of
    stop-go cycle via goods and services prices?

49
Bubbles confuse inflation signals
  • Recent asset price bubbles might have helped to
    dampen up-front inflationary pressures. In case
    of equity market bubbles
  • Artificially boost profits as measured in
    standard accountancy measures firms adopt more
    aggressive pricing strategies
  • Positive feedback via capital accumulation and
    favourable supply-side developments, especially
    productivity gains, the spreading of technology,
    and catch up in emerging economies (c.f.
    China), with consequent lower inflationary
    pressure
  • Firms able to make much lower contributions to
    pension schemes (and employees willingly accept,
    c.f. US 1990s)
  • Employees tolerate less inflationary wage claims
    given perceived gains on stock market investments
    (especially evident in the US in the late 1990s)

50
Bubbles confuse signals, cont.
  • Governments benefit from bubble-inflated asset
    prices that inflate the tax yield (stock market
    taxes at the end of the 1990s, housing
    transactions taxes, consumption taxes, low use of
    pension tax allowances, etc. in current housing
    bubble) and allow them to run lower tax rates
    than otherwise would be the case, even as their
    fiscal positions are strengthened
  • When the bubbles unwind, all these things go into
    reverse just at the wrong time.

51
A public sector generated cash-flow shock?
  • There are dangers in running a fiscal policy that
    risks a sudden tax increase in the face of a
    declining housing market (maybe at the same time
    as a swing in global credit conditions).
  • This time, the impact may show up more than
    usually as a public sector cash-flow problem.
  • But burdens for the public sector are ultimately
    private sector burdens. It is simply an issue of
    timing.
  • If house price falls are slow enough, this
    cash-flow problem can be offloaded to the private
    sector at a more timely pace.

52
Public sector cash-flow, cont.
  • If price falls are more rapid (and confidence
    takes a greater hit) then the cash-flow
    difficulty (or even just expectations of it) may
    be fed much more quickly to the private sector
    especially in the form of higher taxes
    reinforcing the private sectors cash-flow problem
    and putting downward pressure on house prices.
    The economy finds itself on an even higher tax
    trajectory at quite the least opportune time for
    it.
  • And tax rises are hard to target on the
    relatively less indebted (unlike interest rate
    falls).
  • Growing tension between Bank of England and
    Treasury.

53
Precarious balancing act for central banks
  • If rates are raised too slowly, any
    momentum-driven bubbles will expand even further,
    financial imbalances intensify, with inflationary
    pressures built up for the longer term.
    Adjustment is simply delayed till a point when
    the fragility is even greater and when the
    dangers of triggering a switch to deflation are
    higher.
  • If rates raised too quickly, fragilities may
    unwind too fast.
  • Balancing act for debt holders too.
  • This time real price falls will need nominal
    price falls.
  • This time the Bank of England would not allow the
    run-away inflation needed to create the negative
    real interest rates that would generate a similar
    situation today to that easing previous price
    collapses.

54
Central bank difficulties, cont.
  • Interest rates may have too much to do and be
    unable to fall as far as the housing market might
    require
  • If the pound were to weaken too quickly
  • OR oil or commodities prices rise too strongly,
    feeding UK inflationary pressures
  • OR the US were to suffer a fiscal crisis and
    sudden swing in sentiment forcing it to raise
    real interest rates much higher in defense
  • OR UK government finances were to deteriorate
    quickly as lower confidence and economic activity
    reduced the tax yield.
  • Rising spreads may keep interest rates off the
    floor.
  • System has not been stress-tested yet. Best to
    set so as to minimize the fall-out from mistakes.

55
Central banks cont.
  • Policy in the late 1990s settled on price
    stability via interest rate adjustments and not
    tax adjustment, since easier to set up an
    institution independent of elected government.
  • Danger that governments rely on even
    over-exploit the policy credibility created by
    central banks.
  • A slow revision upwards of interest rate
    expectations is better than a sudden unexpected
    tax rise. Gradual reversions without surprises
    are best.
  • Openness about interest rates and at least the
    chance for households to think the scenarios
    through and factor higher interest rates in
    contrasts sharply with the complete lack of
    openness about (and the political nature of) the
    timing and level of future tax rises.

56
A Few Summary Thoughts
  • Global rebalancing at some point.
  • Expected consumption and GDP response will
    matter.
  • Much of the analysis of the consumption response
    is based on efficiently operating bubble-free
    markets.
  • Once we allow bubble mispricing, consumption
    responses are generally not well captured.
  • Soft landing is not fully convincing when a broad
    picture of consumption is considered, including
    pension and savings, and when levels as well as
    changes in levels are reviewed.

Continued on next slide
57
A few summary thoughts cont.
  • Debt-backed housing bubbles probably more
    damaging than stock market bubbles.
  • The new stop-go cycle?
  • Politicians love to exploit bubbles.
  • Aftermath of current period likely to focus
    attention on a wide range of issues. Many of
    these require coordination across diverse
    economies, something usually achieved more easily
    in stable times. In less stable times, something
    much easier to handle if some thought has gone in
    ahead of time.
  • Being better educated helps. Caricature of
    optimists or doomsters, experts or
    pundits does not help.

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