For the majority of people, a house (or flat) is the most valuable thing they will ever own.
It is important to understand the role that house prices play in the economy and how much of an impact they have.
The Bank of England monitors changes in the housing market to assess the risks to the financial system and the wider economy. The housing market employs large numbers of people in construction, sales, furniture and fittings, and accounts for a sizeable percentage of the value of GDP. The market is closely linked to consumer spending and therefore is a crucially important sector of the economy.
The concepts of supply and demand can be applied to understand house price changes and the impacts on the economy.
What is the housing market?
The housing market brings together different stakeholders, such as homeowners who are selling their properties, people seeking to buy a property, renters, investors who buy and sell properties solely for investment purposes, contractors, renovators and estate agents, who act as facilitators in the process of buying or selling a property.
In the UK, two-thirds of households own the property in which they live, and the remaining third of households are renters, split fairly equally between private and social renting. We can thus divide people into:
- Homeowners – either outright owners or with a mortgage;
- Private renters – people renting from private landlords;
- Social renters – people renting from local authorities and housing associations.
There are many determinants of demand and supply in the housing market, many of which are related to demographic factors. Such factors include the size of the market, rate of marriages, divorces, and deaths. However, factors such as income, availability of credit, interest rates and consumer preferences are also important.
Why is the housing market important for the economy?
Changes in the housing market are always given such importance due to the relationship house prices have with consumer spending. Changes in house prices and the number of sales affect how much money people have to spend. Given that household spending accounts for two-thirds of Britain’s total economic activity, any changes in consumption is likely to have a major impact on the wider economy. Observing the housing market helps us to assess the overall demand for goods and services.
When house prices increase, those consumers who own their own homes have now become better off as their houses are worth more. This ‘wealth effect’ increases the confidence of homeowners, which in turn increases consumption. Some of these homeowners will decide to acquire additional borrowing against the value of their home. The borrowing is then spent in the economy on goods and services, thereby increasing aggregate demand and GDP.
However, when house prices decline, homeowners lose confidence as their home is now worth less than before. This becomes a major issue if prices have decreased enough to make their house worth less than the remainder of the unpaid mortgage – known as ‘negative equity’. Homeowners will therefore reduce their consumption and will be less likely to undertake any new borrowing.
The vast majority of homeowners will have taken out a mortgage in order to purchase their home. Mortgages are the largest source of debt for households in the UK. More than 70% of household borrowing is mortgage debt. Half of all homeowners who live in the house they own are still paying off their mortgage. Therefore, households might suddenly hold back on their spending during times of uncertainty because they start to worry about repaying their debts. This has a knock-on effect on the rest of economy, and a small problem can suddenly become a big one.
In addition to affecting overall household spending, the buying and selling of houses also affects the economy directly. Housing investment is a small but unpredictable part of total output in the economy. There are two different ways in which the buying and selling of houses impacts GDP.
The first is when a new build is purchased. This directly contributes to GDP through the investment in the land to build the house on, the purchase of materials and the creation of jobs. Once the homeowners move in they also contribute to the local economy: i.e. shopping at local shops.
The second is when an existing home is bought or sold. The purchase of an existing home does not have the same impact on GDP. However, it does still contribute to GDP: i.e. from estate agents’ and solicitors’ fees and removal costs to the purchase of new furniture.
Why house prices change: demand and supply
Demand: the demand for housing can be defined as the quantity of properties that homebuyers are willing and able to buy at a given price in a given time period. Factors affecting the demand for housing include:
- Real incomes: If real incomes increase the demand for housing increases due to a rise in the standard of living.
- The cost of a mortgage: If there is a rise in interest rates in the economy, mortgage interest rates are likely to rise too. This makes the cost of financing a loan more expensive and therefore will see a decline in demand.
- Availability of credit: The more lending banks and building societies are willing to provide, the more people will borrow and spend on housing and hence the higher house prices will be.
- Economic growth: When the economy is in the recovery and boom stages of the business cycle, wages rise. This will increase the demand for houses.
- Population: When the population increases or if there is an increase in single-person households, demand for housing increases.
- Employment/unemployment: The higher the level of unemployment in an economy, the less people will able to afford housing.
- Confidence: If consumers feel optimistic about the future state of the economy, they will be more likely to go ahead with purchasing a house, thereby increasing demand. House prices tend to rise if people expect to be richer in the future.
Supply: The supply of housing can be defined as the flow of properties available at a given price in a given time period. The supply of housing includes both new-build homes and existing properties. Factors affecting the supply for housing include:
- Costs of production: The higher the cost of production, the fewer houses are built, reducing the supply of housese coming to the market. Example of costs include: labour costs, land for development and building materials.
- Government policy: If the government increases taxation and/or reduces subsidies for new house developments, there will be fewer new houses built.
- Number of construction companies: Depending on their objectives, the more construction companies there are, the more likely there is to be an increase in the supply of housing. The construction industry accounts for around 7% of UK GDP.
- Technology and innovation: With improved technology and innovation in the construction industry, houses become cheaper and easier to build, thus increasing the supply.
- Government spending on building new social housing: The government has the ability to influence the supply of housing by increasing spending on new social housing.
Price elasticity of supply
The supply of new housing in the short run is price inelastic. The main reason for this is the time it takes to build a new home. The production of a house can take many months, from the planning process to the project’s completion. Supply also relies on access to a skilled labour force and the availability of certain construction materials.
Because of the inelastic supply, any changes in demand are likely to have a significant effect on price. This is illustrated by the diagram, which shows a larger proportionate increase in price than quantity when demand increases from D1 to D2.
The current UK housing market
Despite the current economic climate and the effects of the lockdown restrictions on consumers, house prices have increased, and sales have now resumed. Rightmove, which advertises 95% of homes for sale, states that the housing market has seen its busiest month in more than 10 years in July. During the summer, the housing market usually sees a lull in activity. However, since the easing of lockdown, there has been a flurry of activity from buyers and sellers. Since July 2019, house prices have increased by 1.7%, according to the Nationwide Building Society.
London estate agency, Hamptons, states that homeowners are now bringing forward their moving plans as the experience of lockdown has encouraged them to seek more space. The mortgage market is also very favourable right now in terms of interest rates, and rental demand is continuing to surge across the UK.
The increase in activity in the market has also been helped by the announcement of a stamp duty ‘holiday’ until March 2021. This sees the threshold above which stamp duty is paid rising from £125 000 to £500 000. Estate agency, Savills, has also seen an increase in the number of new buyers registering with its service, more than double the number registered in July 2019. It is thought that, along with the tax savings from stamp duty, people’s experiences in lockdown have made them evaluate their current living space and reconsider their housing needs.
However, given the that the economy is experiencing its deepest recession on record, there is concern about just how long the market can resist the economic forces pulling prices down.
Historically, a drop in house prices has been both a cause and a consequence of economic recessions. During the 2008 financial crisis, house prices fell by about 30%. As previously mentioned, for the majority of people, a house is the most valuable thing they will ever own and therefore consumers are extremely interested in its value. Consumer confidence is one of the key factors affecting the demand for housing. If consumers feel pessimistic about the future state of the economy, they will be less likely to go ahead with purchasing a house, thereby decreasing demand. Britain’s Office for Budget Responsibility, the country’s fiscal watchdog, forecasts that during this downturn prices will fall 5% this year and 11% in 2021.
Various government schemes put in place to help during lockdown are starting to come to an end. The main one – the furlough scheme, which replaced 80% of eligible workers’ incomes – comes to an end in October. It is forecast that labour market conditions will weaken significantly in the quarters ahead, with unemployment predicted to rise for the rest of the year. If these predictions materialise, it would likely dampen housing activity once again.
Fluctuations in house prices and transactions tend to amplify the volatility of the economic cycle. Therefore, it is crucial that we understand what influences such changes. Understanding how supply and demand factors influence the housing market can enable key stakeholders to make better predictions about future activity and plan accordingly. The current market has seen a growth since the easing of restrictions but there is concern that this has been powered by pent-up demand. Therefore, the outlook for house prices is uncertain and the full effects of an economic downturn are yet to be realised.
- Explain why the supply of housing is inelastic in the short-term.
- Given that the elasticity of housing supply in the UK is low, what policies could be introduced to ensure that house building is more responsive to changes in market demand?
- If unemployment does increase as predicted, explain what impact this would have on the demand in the housing market and house prices? Use a supply and demand diagram to aid your answer.
- Explain how changes in house prices affect the government’s key macroeconomic objectives.
Share prices are determined by demand and supply. The same applies to stock market indices, such as the FTSE 100 and FTSE 250 in the UK and the Dow Jones Industrial Average and the S&P 500 in the USA. After all, the indices are the weighted average prices of the shares included in the index. Generally, when economies are performing well, or are expected to do so, share prices will rise. They are likely to fall in a recession or if a recession is anticipated. A main reason for this is that the dividends paid on shares will reflect the profitability of firms, which tends to rise in times of a buoyant economy.
When it first became clear that Covid-19 would become a pandemic and as countries began locking down, so stock markets plummeted. People anticipated that many businesses would fail and that the likely recession would cause profits of many other surviving firms to decline rapidly. People sold shares.
The first chart shows how the FTSE 100 fell from 7466 in early February 2020 to 5190 in late March, a fall of 30.5%. The Dow Jones fell by 34% over the same period. In both cases the fall was driven not only by the decline in the respective economy over the period, but by speculation that further declines were to come (click here for a PowerPoint of the chart).
But then stock markets started rising again, especially the Dow Jones, despite the fact that the recessions in the UK, the USA and other countries were gathering pace. In the second quarter of 2020, the Dow Jones rose by 23% and yet the US economy declined by 33% – the biggest quarterly decline on record. How could this be explained by supply and demand?
In order to boost aggregate demand and reduce the size of the recession, central banks around the world engaged in large-scale quantitative easing. This involves central banks buying government bonds and possibly corporate bonds too with newly created money. The extra money is then used to purchase other assets, such as stocks and shares and property, or physical capital or goods and services. The second chart shows that quantitative easing by the Bank of England increased the Bank’s asset holding from April to July 2020 by 50%, from £469bn to £705bn (click here for a PowerPoint of the chart).
But given the general pessimism about the state of the global economy, employment and personal finances, there was little feed-through into consumption and investment. Instead, most of the extra money was used to buy assets. This gave a huge boost to stock markets. Stock market movements were thus out of line with movements in GDP.
Stock market prices do not just reflect the current economic and financial situation, but also what people anticipate the situation to be in the future. As infection and death rates from Covid-19 waned around Europe and in many other countries, so consumer and business confidence rose. This is illustrated in the third chart, which shows industrial, consumer and construction confidence indicators in the EU. As you can see, after falling sharply as the pandemic took hold in early 2020 and countries were locked down, confidence then rose (click here for a PowerPoint of the chart).
But, as infection rates have risen somewhat in many countries and continue to soar in the USA, Brazil, India and some other countries, this confidence may well start to fall again and this could impact on stock markets.
A final, but related, cause of recent stock market movements is speculation. If people see share prices falling and believe that they are likely to fall further, then they will sell shares and hold cash or safer assets instead. This will amplify the fall and encourage further speculation. If, however, they see share prices rising and believe that they will continue to do so, they are likely to want to buy shares, hoping to make a gain by buying them relatively cheaply. This will amplify the rise and, again, encourage further speculation.
If there is a second wave of the pandemic, then stock markets could well fall again, as they could if speculators think that share prices have overshot the levels that reflect the economic and financial situation. But then there may be even further quantitative easing.
There are many uncertainties, both with the pandemic and with governments’ policy responses. These make forecasting stock market movements very difficult. Large gains or large losses could await people speculating on what will happen to share prices.
- Illustrate the recent movements of stock markets using demand and supply diagrams. Explain your diagrams.
- What determines the price elasticity of demand for shares?
- Distinguish between stabilising and destabilising speculation. How are the concepts relevant to the recent history of stock market movements?
- Explain how quantitative easing works to increase (a) asset prices; (b) aggregate demand.
- What is the difference between quantitative easing as currently conducted by central banks and ‘helicopter money‘?
- Give some examples of companies whose share prices have risen strongly since March 2020. Explain why these particular shares have done so well.
Economists are often criticised for making inaccurate forecasts and for making false assumptions. Their analysis is frequently dismissed by politicians when it contradicts their own views.
But is this fair? Have economists responded to the realities of the global economy and to the behaviour of people, firms, institutions and government as they respond to economic circumstances? The answer is a qualified yes.
Behavioural economics is increasingly challenging the simple assumption that people are ‘rational’, in the sense that they maximise their self interest by weighing up the marginal costs and benefits of alternatives open to them. And macroeconomic models are evolving to take account of a range of drivers of global growth and the business cycle.
The linked article and podcast below look at the views of 2019 Nobel Prize-winning economist Esther Duflo. She has challenged some of the traditional assumptions of economics about the nature of rationality and what motivates people. But her work is still very much in the tradition of economists. She examines evidence and sees how people respond to incentives and then derives policy implications from the analysis.
Take the case of the mobility of labour. She examines why people who lose their jobs may not always move to a new one if it’s in a different town. Partly this is for financial reasons – moving is costly and housing may be more expensive where the new job is located. Partly, however, it is for reasons of identity. Many people are attached to where they currently live. They may be reluctant to leave family and friends and familiar surroundings and hope that a new job will turn up – even if it means a cut in wages. This is not irrational; it just means that people are driven by more than simply wages.
Duflo is doing what economists typically do – examining behaviour in the light of evidence. In her case, she is revisiting the concept of rationality to take account of evidence on what motivates people and the way they behave.
In the light of workers’ motivation, she considers the implications for the gains from trade. Is free trade policy necessarily desirable if people lose their jobs because of cheap imports from China and other developing countries where labour costs are low?
The answer is not a clear yes or no, as import-competing industries are only part of the story. If protectionist policies are pursued, other countries may retaliate with protectionist policies themselves. In such cases, people working in the export sector may lose their jobs.
She also looks at how people may respond to a rise or cut in tax rates. Again the answer is not clear cut and an examination of empirical evidence is necessary to devise appropriate policy. Not only is there an income and substitution effect from tax changes, but people are motivated to work by factors other than take-home pay. Likewise, firms are encouraged to invest by factors other than the simple post-tax profitability of investment.
- In traditional ‘neoclassical’ economics, what is meant by ‘rationality’ in terms of (a) consumer behaviour; (b) producer behaviour?
- How might the concept of rationality be expanded to take into account a whole range of factors other than the direct costs and benefits of a decision?
- What is meant by bounded rationality?
- What would be the effect on workers’ willingness to work more or fewer hours as a result of a cut in the marginal income tax rate if (a) the income effect was greater than the substitution effect; (b) the substitution effect was greater than the income effect? Would your answers to (a) and (b) be the opposite in the case of a rise in the marginal income tax rate?
- Give some arguments that you consider to be legitimate for imposing controls on imports in (a) the short run; (b) the long run. How might you counter these arguments from a free-trade perspective?
The USA has seen many horizontal mergers in recent years. This has turned industries that were once relatively competitive into oligopolies, resulting in lower output and higher prices for consumers.
In Europe, by contrast, many markets are becoming more competitive. The result is that in industries such as mobile phone services, airlines and broadband provision, prices are considerably lower in most European countries than in the USA. As the French economist, Thomas Philippon, states in a Guardian article:
When I landed in Boston in 1999, the United States was the land of free markets. Many goods and services were cheaper than in Europe. Twenty years later, American free markets are becoming a myth.
According to Asher Schechter (see linked article below):
Nearly every American industry has experienced an increase in concentration in the last two decades, to the point where … sectors dominated by two or three firms are not the exception, but the rule.
The result has been an increase in deadweight loss, which, according to research by Bruno Pelligrino, now amounts to some 13.3 per cent of total potential surplus.
Philippon in his research estimates that monopolies and oligopolies “cost the median American household about $300 a month” and deprive “American workers of about $1.25tn of labour income every year”.
One industry considered by the final two linked articles below is housebuilding. Since the US housing and financial crash of 2007–8 many US housebuilders have gone out of business. This has meant that the surviving companies have greater market power. According to Andrew van Dam in the linked Washington Post article below:
They have since built on that advantage, consolidating until many markets are controlled by just a few builders. Their power has exacerbated the country’s affordable-housing crisis, some economists say.
According to research by Luis Quintero and Jacob Cosman:
… this dwindling competition has cost the country approximately 150 000 additional homes a year – all else being equal. With fewer competitors, builders are under less pressure to beat out rival projects, and can time their efforts so that they produce fewer homes while charging higher prices.
Thanks to lobbying of regulators and politicians by businesses and various unfair, but just about legal, practices to exclude rivals, competition policy in the USA has been weak.
In the EU, by contrast, the competition authorities have been more active and tougher. For example, in the airline industry, EU regulators have “encouraged the entry of low-cost competitors by making sure they could get access to takeoff and landing slots.” Politicians from individual EU countries have generally favoured tough EU-wide competition policy to prevent companies from other member states getting an unfair advantage over their own country’s companies.
- What are the possible advantages and disadvantages of oligopoly compared with markets with many competitors?
- How can concentration in an industry be measured?
- Why have US markets become more concentrated?
- Why have markets in the EU generally become more competitive?
- Find out what has happened to levels of concentration in the UK housebuilding market.
- What are the possible effects of Brexit on concentration and competition policy in the UK?
The latest UK house price index reveals that annual house price growth in the UK slowed to just 1.2 per cent in May. This is the lowest rate of growth since January 2013. This is being driven, in part, by the London market where annual house price inflation rates have now been negative for 15 consecutive months. In May the annual rate of house price inflation in London fell to -4.4 per cent, it lowest since August 2009 as the financial crisis was unfolding. However, closer inspection of the figures show that while many other parts of the country continue to experience positive rates of annual house price inflation, once general inflation is accounted for, there is widespread evidence of widespread real house price deflation.
The average UK house price in May 2019 was £229,000. As Chart 1 shows, this masks considerable differences across the UK. In England the average price was £246,000 (an annual increase of 1.0 per cent), in Scotland it was £153,000 (an increase of 2.8 per cent), in Wales £159,000 (an increase of 3.0 per cent) and in Northern Ireland it was £137,000 (an increase of 2.1 per cent). (Click here to download a PowerPoint copy of the chart.)
The London market distorts considerably the English house price figures. In London the average house price in May 2019 was £457,000 (an annual decrease of 4.4 per cent). House prices were lowest in the North East region of England at £128,000. The North East was the only other English region alongside London to witness a negative rate of annual house price inflation, with house prices falling in the year to May 2019 by 0.7 per cent.
Chart 2 allows us to see more readily the rates of house price growth. It plots the annual rates of house price inflation across London, the UK and its nations. What is readily apparent is the volatility of house price growth. This is evidence of frequent imbalances between the flows of property on to the market to sell (instructions to sell) and the number of people looking to buy (instructions to buy). An increase in instructions to buy relative to those to sell puts upwards pressure on prices whereas an increase in the relative number of instructions to sell puts downward pressure on prices. (Click here to download a PowerPoint copy of the chart.)
Despite the volatility in house prices, the longer-term trend in house prices is positive. The average annual rate of growth in house prices between January 1970 and May 2019 in the UK is 9.1 per cent. For England the figure is 9.4 per cent, for Wales 8.8 per cent, for Scotland 8.5 per cent and for Northern Ireland 8.3 per cent. In London the average rate of growth is 10.4 per cent per annum.
As Chart 3 illustrates, the longer-term growth in actual house prices cannot be fully explained by the growth in consumer prices. It shows house price values as if consumer prices, as measured by the Retail Prices Index (RPI), were fixed at their January 1987 levels. We see real increases in house prices or, expressed differently, in house prices relative to consumer prices. In real terms, UK house prices were 3.6 times higher in May 2019 compared to January 1970. For England the figure is 4.1 times, for Wales 3.1 times, for Scotland 2.9 times and for Northern Ireland 2.1 times. In London inflation-adjusted house prices were 5.7 times higher. (Click here to download a PowerPoint copy of the chart.)
The volatility in house prices continues to be evident when adjusted for changes in consumer prices. The UK’s annual rate of real house price inflation was as high as 40 per in January 1973, yet, on the other hand, in June 1975 inflation-adjusted house prices were 16 per cent lower than a year earlier. Over the period from January 1970 to May 2019, the average annual rate of real house price inflation was 3.2 per cent. Hence house prices have, on average, grown at an annual rate of consumer price inflation plus 3.2 per cent.
Chart 4 shows annual rates of real house price inflation since 2008 and, hence, from around the time the financial crisis began to unfold. The period is characterised by acute volatility and with real house prices across the UK falling at an annual rate of 16 per cent in 2009 and by as much 29 per cent in Northern Ireland. (Click here to download a PowerPoint copy of the chart.)
The UK saw a rebound in nominal and real house price growth in the period from 2013, driven by a strong surge in prices in London and the South East, and supported by government initiatives such as Help to Buy designed to help people afford to buy property. But house price growth then began to ease from early/mid 2016. Some of the easing may be partly due to any excessive fizz ebbing from the market, especially in London, and the impact on the demand for buy-to-let investments resulting from reductions in tax relief on interest payments on buy-to-let mortgages.
However, the housing market is notoriously sensitive to uncertainty, which is not surprising when you think of the size of the investment people are making when they enter the market. The uncertainty surrounding Brexit and the UK’s future trading relationships will have been a drag on demand and hence on house prices.
Chart 4 shows that by May 2019 all the UK nations were experiencing negative rates of real house price inflation, despite still experiencing positive rates of nominal house price inflation. In Wales the real annual house price inflation rate was -0.1 per cent, in Scotland -0.2 per cent, in Northern Ireland -0.9 per cent and in England -2.0 per cent. Meanwhile in London, where annual house price deflation has been evident for 15 consecutive months, real house prices in May 2019 were falling at an annual rate of 7.2 per cent.
Going forward the OBR’s Fiscal Risks Report predicts that, in the event of a no-deal, no-transition exit of the UK from the European Union, nominal UK house prices would fall by almost 10 per cent between the start of 2019 and mid-2021. This forecast is driven by the assumption that the UK would enter a year-long recession from the final quarter of 2019. It argues that property transactions and prices ‘move disproportionately’ during recessions. (See John’s blog The costs of a no-deal Brexit for a fuller discussion of the economics of a no-deal Brexit). The danger therefore is that the housing market becomes characterised by both nominal and real house price falls.
- Explain the difference between a rise in the rate of house price inflation a rise in the level of house prices.
- Explain the difference between nominal and real house prices.
- If nominal house prices rise can real house price fall? Explain your answer.
- What do you understand by the terms instructions to buy and instructions to sell?
- What factors are likely to affect the levels of instructions to buy and instructions to sell?
- How does the balance between instructions to buy and instructions to sell affect house prices?
- How can we differentiate between different housing markets? Illustrate your answer with examples.