Category: Essential Economics for Business: Ch 10

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Deeper in debt

On 25 November, the UK government published its Spending Review 2020. This gives details of estimated government expenditure for the current financial year, 2020/21, and plans for government expenditure and the likely totals for 2021/22.

The focus of the Review is specifically on the effects of and responses to the coronavirus pandemic. It does not consider the effects of Brexit, with or without a trade deal, or plans for taxation. The Review is based on forecasts by the Office for Budget Responsibility (OBR). Because of the high degree of uncertainty over the spread of the disease and the timing and efficacy of vaccines, the OBR gives three forecast values for most variables – pessimistic, central and optimistic.

According to the central forecast, real GDP is set to decline by 11.3% in 2020, the largest one-year fall since the Great Frost of 1709. The economy is then set to ‘bounce back’ (somewhat), with GDP rising by 5.2% in 2021.

Unemployment will rise from 3.9% in 2019 to a peak of 7.5% in mid-2021, after the furlough scheme and other support for employers is withdrawn.

This blog focuses at the impact on government borrowing and debt and the implications for the future – both the funding of the debt and ways of reducing it.

Soaring government deficits and debt


Government expenditure during the pandemic has risen sharply through measures such as the furlough scheme, the Self-Employment Income Support Scheme and various business loans. This, combined with falling tax revenue, as incomes and consumer expenditure have declined, has led to a rise in public-sector net borrowing (PSNB) from 2.5% of GDP in 2019/20 to a central forecast of 19% for 2020/21 – the largest since World War II. By 2025/26 it is still forecast to be 3.9% of GDP. The figure has also been pushed up by a fall in nominal GDP for 2020/21 (the denominator) by nearly 7%. (Click here for a PowerPoint of the above chart.)

The high levels of PSNB are pushing up public-sector net debt (PSNB). This is forecast to rise from 85.5% of GDP in 2019/20 to 105.2% in 2020/21, peaking at 109.4% in 2023/24.

The exceptionally high deficit and debt levels will mean that the government misses by a very large margin its three borrowing and debt targets set out in the latest (Autumn 2016) ‘Charter for Budget Responsibility‘. These are:

  • to reduce cyclically-adjusted public-sector net borrowing to below 2% of GDP by 2020/21;
  • for public-sector net debt as a percentage of GDP to be falling in 2020/21;
  • for overall borrowing to be zero or in surplus by 2025/26.

But, as the Chancellor said in presenting the Review:

Our health emergency is not yet over. And our economic emergency has only just begun. So our immediate priority is to protect people’s lives and livelihoods.

Putting the public finances on a sustainable footing

Running a large budget deficit in an emergency is an essential policy for dealing with the massive decline in aggregate demand and for supporting those who have, or otherwise would have, lost their jobs. But what of the longer-term implications? What are the options for dealing with the high levels of debt?

1. Raising taxes. This tends to be the preferred approach of those on the left, who want to protect or improve public services. For them, the use of higher progressive taxes, such as income tax, or corporation tax or capital gains tax, are a means of funding such services and of providing support for those on lower incomes. There has been much discussion of the possibility of finding a way of taxing large tech companies, which are able to avoid taxes by declaring very low profits by diverting them to tax havens.

2. Cutting government expenditure. This is the traditional preference of those on the right, who prefer to cut the overall size of the state and thus allow for lower taxes. However, this is difficult to do without cutting vital services. Indeed, there is pressure to have higher government expenditure over the longer term to finance infrastructure investment – something supported by the Conservative government.

A downside of either of the above is that they squeeze aggregate demand and hence may slow the recovery. There was much discussion after the financial crisis over whether ‘austerity policies’ hindered the recovery and whether they created negative supply-side effects by dampening investment.

3. Accepting higher levels of debt into the longer term. This is a possible response as long as interest rates remain at record low levels. With depressed demand, loose monetary policy may be sustainable over a number of years. Quantitative easing depresses bond yields and makes it cheaper for governments to finance borrowing. Servicing high levels of debt may be quite affordable.

The problem is if inflation begins to rise. Even with lower aggregate demand, if aggregate supply has fallen faster because of bankruptcies and lack of investment, there may be upward pressure on prices. The Bank of England may have to raise interest rates, making it more expensive for the government to service its debts.

Another problem with not reducing the debt is that if another emergency occurs in the future, there will be less scope for further borrowing to support the economy.

4. Higher growth ‘deals’ with the deficit and reduces debt. In this scenario, austerity would be unnecessary. This is the ‘golden’ scenario – for the country to grow its way out of the problem. Higher output and incomes leads to higher tax revenues, and lower unemployment leads to lower expenditure on unemployment benefits. The crucial question is the relationship between aggregate demand and supply. For growth to be sustainable and shrink the debt/GDP ratio, aggregate demand must expand steadily in line with the growth in aggregate supply. The faster aggregate supply can grow, the faster can aggregate demand. In other words, the faster the growth in potential GDP, the faster can be the sustainable rate of growth of actual GDP and the faster can the debt/GDP ratio shrink.

One of the key issues is the degree of economic ‘scarring’ from the pandemic and the associated restrictions on economic activity. The bigger the decline in potential output from the closure of firms and the greater the deskilling of workers who have been laid off, the harder it will be for the economy to recover and the longer high deficits are likely to persist.

Another issue is the lack of labour productivity growth in the UK in recent years. If labour productivity does not increase, this will severely restrict the growth in potential output. Focusing on training and examining incentives, work practices and pay structures are necessary if productivity is to rise significantly. So too is finding ways to encourage firms to increase investment in new technologies.

Podcast and videos

Articles

OBR Data

Questions

  1. What is the significance of the relationship between the rate of economic growth and the rate of interest for financing public-sector debt over the longer term?
  2. What can the government do to encourage investment in the economy?
  3. Using OBR data, find out what has happened to the output gap over the past few years and what is forecast to happen to it over the next five years. Explain the significance of the figures.
  4. Distinguish between demand-side and supply-side policies. How would you characterise the policies to tackle public-sector net debt in terms of this distinction? Do the policies have a mixture of demand- and supply-side effects?
  5. Choose two other developed countries. Examine how their their public finances have been affected by the coronavirus pandemic and the policies they are adopting to tackle the economic effects of the pandemic.
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The macroeconomic outlook over the next few years: a Covid hangover

Back in June, we examined the macroeconomic forecasts of the three agencies, the IMF, the OECD and the European Commission, all of which publish forecasts every six months. The IMF has recently published its latest World Economic Outlook (WEO) and its accompanying database. Unlike the April WEO, which, given the huge uncertainty surrounding the pandemic and its economic effects, only forecast as far as 2021, the latest version forecasts as far ahead as 2025.

In essence the picture is similar to that painted in April. The IMF predicts a large-scale fall in GDP and rise in unemployment, government borrowing and government debt for 2020 (compared with 2019) across virtually all countries.

World real GDP is predicted to fall by 4.4%. For many countries the fall will be much steeper. In the UK, GDP is predicted to fall by 9.8%; in the eurozone, by 8.3%; in India, by 10.3%; in Italy, by 10.8%; in Spain, by 12.8%. There will then be somewhat of a ‘bounce back’ in GDP in 2021, but not to the levels of 2019. World real GDP is predicted to rise by 5.2% in 2021. (Click here for a PowerPoint of the growth chart.)

Unemployment will peak in some countries in 2020 and in others in 2021 depending on the speed of recovery from recession and the mobility of labour. (Click here for a PowerPoint of the unemployment chart.)

Inflation is set to fall from already low levels. Several countries are expected to see falling prices.

Government deficits (negative net lending) will be sharply higher in 2020 as a result of government measures to support workers and firms affected by lockdowns and falling demand. Governments will also receive reduced tax revenues. (Click here for a PowerPoint of the general government net lending chart.)

Government debt will consequently rise more rapidly. Deficits are predicted to fall in 2021 as economies recover and hence the rise in debt will slow down or in some cases, such as Germany, even fall. (Click here for a PowerPoint of the general government gross debt chart.)

After the rebound in 2021, global growth is then expected to slow to around 3.5% by 2025. This compares with an average of 3.8% from 2000 to 2019. Growth of advanced economies is expected to slow to 1.7%. It averaged 1.9% from 2000 to 2019. For emerging market and developing countries it is expected to slow to 4.7% from an average of 5.7% from 2000 to 2019. These figures suggest some longer-term scarring effects from the pandemic.

Uncertainties

In the short term, the greatest uncertainty concerns the extent of the second wave, the measures put in place to contain the spread of the virus and the compensation provided by governments to businesses and workers. The WEO report was prepared when the second wave was only just beginning. It could well be that countries will experience a deeper recession in 2000 and into 2021 than predicted by the IMF.

This is recognised in the forecast.

The persistence of the shock remains uncertain and relates to factors inherently difficult to predict, including the path of the pandemic, the adjustment costs it imposes on the economy, the effectiveness of the economic policy response, and the evolution of financial sentiment.

With some businesses forced to close, others operating at reduced capacity because of social distancing in the workplace and with dampened demand, many countries may find output falling again. The extent will to a large extent depend on the levels of government support.

In the medium term, it is assumed that there will be a vaccine and that economies can begin functioning normally again. However, the report does recognise the long-term scarring effects caused by low levels of investment, deskilling and demotivation of the parts of the workforce, loss of capacity and disruptions to various supply chains.

The deep downturn this year will damage supply potential to varying degrees across economies. The impact will depend on various factors … including the extent of firm closures, exit of discouraged workers from the labour force, and resource mismatches (sectoral, occupational and geographic).

One of the greatest uncertainties in the medium term concerns the stance of fiscal and monetary policies. Will governments continue to run large deficits to support demand or will they attempt to reduce deficits by raising taxes and/or reducing benefits and/or cutting government current or capital expenditure?

Will central banks continue with large-scale quantitative easing and ultra-low or even negative interest rates? Will they use novel forms of monetary policy, such as directly funding government deficits with new money or providing money directly to citizens through a ‘helicopter’ scheme (see the 2016 blog, New UK monetary policy measures – somewhat short of the kitchen sink)?

Forecasting at the current time is fraught with uncertainty. However, reports such as the WEO are useful in identifying the various factors influencing the economy and how seriously they may impact on variables such as growth, unemployment and government deficits.

Report, speeches and data

Articles

Questions

  1. Explain what is meant by ‘scarring effects’. Identify various ways in which the pandemic is likely to affect aggregate supply over the longer term.
  2. Consider the arguments for and against governments continuing to run large budget deficits over the next few years.
  3. What are the arguments for and against using ‘helicopter money’ in the current circumstances?
  4. On purely economic grounds, what are the arguments for imposing much stricter lockdowns when Covid-19 rates are rising rapidly?
  5. Chose two countries other than the UK, one industrialised and one developing. Consider what policies they are pursuing to achieve an optimal balance between limiting the spread of the virus and protecting the economy.
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The new UK Job Support Scheme: how much will it slow the rise in unemployment?

In March 2020, the UK government introduced a Coronavirus Job Retention Scheme. Businesses that had to close or cut back could put staff on furlough and the scheme would allow employers to claim 80% of workers’ wages up to £2500 per month. This would be passed on to workers.

There was large-scale uptake of the scheme. By the end of August, 9.6 million employees were on furlough (28% of the workforce) from around 1.2 million employers (61% of eligible employers). The scheme significantly stemmed the rise in unemployment. The claimant count rose 121% from March to August from 1.24 million to 2.74 million, far less than it would have done without the furlough scheme.

Since 1 August the level of support has been reduced in stages and is due to end on 31 October. It will then be replaced by a new ‘Job Support Scheme (JSS)‘ running from 1 November 2020 to 30 April 2021. Initially, employees must work at least 33% of their usual hours. For hours not worked, the government and the employer will pay a third each. There would be no pay for the final third. This means that an employee would receive at least 77.7% (33% + (2/3)67%) of their full pay – not far short of the 80% under the furlough scheme.

Effects on unemployment

Will the scheme see a substantial rise in unemployment, or will it be enough to support a gradual recovery in the economy as more businesses are able to reopen or take on more staff?

On first sight, it might seem that the scheme will give only slightly less job protection than the job furlough scheme with employees receiving only a little less than before. But, unlike the previous scheme, employers will have to pay not only for work done, but also an additional one-third for work not done. This is likely to encourage employers to lay off part of their staff and employ the remainder for more than one-third of their usual hours. Other firms may simply not engage with the scheme.

What is more, the furlough scheme paid wages for those previously employed by firms that were now closed. Under the new scheme, employees of firms that are forced to stay closed, such as many in the entertainments industry, will receive nothing. They will lose their jobs (at least until such firms are able to reopen) and will thus probably have to look for a new job. The scheme does not support them.

The government acknowledges that some people will lose their jobs but argues that it should not support jobs that are no longer viable. The question here is whether some jobs will eventually become viable again when the Covid restrictions are lifted.

With Covid cases on the rise again and more restrictions being imposed, especially at a local level, it seems inevitable that unemployment will continue to rise for some time with the ending of the furlough scheme and as the demand for labour remains subdued. The ending of the new scheme in April could compound the problem. Even when unemployment does begin to fall, it may take many months to return to pre-pandemic levels.

Update: expansion of the scheme

On 9 October, with Covid-19 cases rising rapidly in some parts of the country and tighter restrictions being imposed, the government announced that it was extending the scheme. From 1 November, employees of firms in certain parts of the country that would be required to close by the government, such as bars and restaurants, would be paid two-thirds of their previous wages by the government.

Critics of this extension to the scheme argue many firms will still be forced to shut because of lack of demand, even though they are not legally being required close. Employees of such firms will receive nothing from the scheme and will be forced onto Universal Credit. Also, the scheme will mean that many of the workers who do receive the money from the government will still face considerable hardship. Many will previously have been on minimum wages and thus will struggle to manage on only two-thirds of their previous wages.

Articles

Articles: update

Government information

Questions

  1. If people on furlough were counted as unemployed, find out what would have happened to the unemployment rate between March and August 2020.
  2. If an employer were previously employing two people doing the same type of job and now has enough work for only one person, under the Job Support Scheme would it be in the employers’ financial interest to employ one worker full time and make the other redundant or employ both of the workers half time? Explain your arguments.
  3. What are the arguments for and against the government supporting jobs for more than a few months?
  4. What determines the mobility of labour? What policies could the government pursue to increase labour mobility?
  5. Find out what policies to support employment or wages have been pursued by two other countries since the start of the pandemic. Compare them with the policies of the UK government.
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Fed adopts new monetary targets

In the current environment of low inflation and rising unemployment, the Federal Reserve Bank, the USA’s central bank, has amended its monetary targets. The new measures were announced by the Fed chair, Jay Powell, in a speech for the annual Jackson Hole central bankers’ symposium (this year conducted online on August 27 and 28). The symposium was an opportunity for central bankers to reflect on their responses to the coronavirus pandemic and to consider what changes might need to be made to their monetary policy targets and instruments.

The Fed’s previous targets

Previously, like most other central banks, the Fed had a long-run inflation target of 2%. It did, however, also seek to ‘maximise employment’. In practice, this meant seeking to achieve a ‘normal’ rate of unemployment, which the Fed regards as ranging from 3.5 to 4.7% with a median value of 4.1%. The description of its objectives stated that:

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.

The new targets

Under the new system, the Fed has softened its inflation target. It will still be 2% over the longer term, but it will be regarded as an average, rather than a firm target. The Fed will be willing to see inflation above 2% for longer than previously before raising interest rates if this is felt necessary for the economy to recover and to achieve its long-run potential economic growth rate. Fed chair, Jay Powell, in a speech on 27 August said:

Following periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2 per cent for some time.

Additionally, the Fed has increased its emphasis on employment. Instead of focusing on deviations from normal employment, the Fed will now focus on the shortfall of employment from its normal level and not be concerned if employment temporarily exceeds its normal level. As Powell said:

Going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals

The Fed will also take account of the distribution of employment and pay more attention to achieving a strong labour market in low-income and disadvantaged communities. However, apart from the benefits to such communities from a generally strong labour market, it is not clear how the Fed could focus on disadvantaged communities through the instruments it has at its disposal – interest rate changes and quantitative easing.

Assessment

Modern monetary theorists (see blog MMT – a Magic Money Tree or Modern Monetary Theory?) will welcome the changes, arguing that they will allow more aggressive expansion and higher government borrowing at ultra-low interest rates.

The problem for the Fed is that it is attempting to achieve more aggressive goals without having any more than the two monetary instruments it currently has – lowering interest rates and increasing money supply through asset purchases (quantitative easing). Interest rates are already near rock bottom and further quantitative easing may continue to inflate asset prices (such as share and property prices) without sufficiently stimulating aggregate demand. Changing targets without changing the means of achieving them is likely to be unsuccessful.

It remains to be seen whether the Fed will move to funding government borrowing directly, which could allow for a huge stimulus through infrastructure spending, or whether it will merely stick to using asset purchases as a way for introducing new money into the system.

Articles

Speeches

Questions

  1. Find out how much asset purchases by the Fed, the Bank of England and the ECB have increased in the current rounds of quantitative easing.
  2. How do asset purchases affect narrow money, broad money and aggregate demand? Is there a fixed money multiplier effect between the narrow money increases and aggregate demand? Explain.
  3. Why did the dollar exchange rate fall following the announcement of the new measures by Jay Powell?
  4. The Governor of the Bank of England, Andrew Bailey, also gave a speech at the Jackson Hole symposium. How does the approach to money policy outlined by Bailey differ from that outlined by Jay Powell?
  5. What practical steps, if any, could a central bank take to improve the relative employment prospects of disadvantaged groups?
  6. Outline the arguments for and against central banks directly funding government expenditure through money creation.
  7. What longer-term problems are likely to arise from central banks pursuing ultra-low interest rates for an extended period of time?
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Supply and demand: the housing market

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.

Conclusion

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.

Articles

Questions

  1. Explain why the supply of housing is inelastic in the short-term.
  2. 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?
  3. 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.
  4. Explain how changes in house prices affect the government’s key macroeconomic objectives.