High UK house prices increase the probability of a crash – and it''s this factor which may make houses more affordable in the long run, according to research by Geoffrey Meen, Alexander Mihailov and Yehui Wang, to be presented at the Royal Economic Society''s annual conference at the University of Bristol in April 2017.
Housing policy, designed to improve affordability, has concentrated on measures to increase housing supply. But there is not much good news for buyers frozen out of the market: because supply cannot hope to keep pace with the growth of the economy, the ratio of house prices to incomes is unlikely to improve much in the long run.
The analysis presented in this study suggests that affordability will be improved by another factor: housing risk. The researchers find that even modest shocks to the economy – for example, to household income – could stabilise affordability. The problem is that this would be at the cost of a major housing market crash.
The authors conclude: ''Market crashes are hardly an optimal policy response to improving affordability, given the wider effects on the economy. If reliance on supply expansion is inadequate, then this implies the need for more integrated housing policies, where housing issues play a wider role in macroeconomic policies.''
Despite the strengthening of controls on mortgage lending after the Global Financial Crisis, it would be optimistic and, indeed, complacent to suggest that there will be no future housing crises. History is littered with recurrent housing booms and slumps, not only in the UK, but also internationally.
In anticipation, a Reading University team is undertaking a major research programme into the UK''s stubborn long-run housing affordability and cyclical problems, going beyond the more conventional approaches. In particular, it questions the over-emphasis on housing supply expansion alone as the sole cure to Britain''s difficulties.
Housing policy, designed to improve affordability, has concentrated heavily on measures to increase housing supply and the UK is not alone in this approach. The recent housing White Paper reinforced this message and was also emphasised by the House of Lords in a report published last July.
But without under-estimating the importance of housing supply, we have known since the Barker Review of Housing Supply in 2004 that the increases in housing supply required to improve affordability have to be very large and long-lasting; the step change would need to be much larger than has ever been experienced before on a permanent basis.
The formal conditions required to stabilise affordability are now known; in the long run, the housing stock must grow at the same rate as real household income. This condition is straightforward but probably impossible to achieve – in practice, the housing stock grows much more slowly than the economy as a whole.
Furthermore, the greater is the responsiveness of housing demand to changes in income, the faster affordability is likely to worsen. This does not imply that supply policies should be abandoned, but their limitations need to recognised and, probably, enhanced by demand-side measures as well.
A further strand of our research indicates that a key difference from Germany – where affordability has not worsened – relates to demand just as much as supply.
Nevertheless, as the paper explores, there appears to be an inconsistency between this view and the observation that affordability (measured by the ratio of house prices to incomes) has shown only limited signs of worsening in the long run.
It is true that affordability has declined in recent years, but this is largely explainable in terms of low borrowing costs and yields on alternative assets, which encourage investment demand. Therefore, there is likely to be some feature missing from conventional housing models that can explain the limited long-run worsening of affordability even when supply provision is weak.
Other macroeconomic influences have played a role, but a missing link is risk; at one level, it is obvious that at times of high house prices, the probability of market collapse increases – although this appears to have been ignored during the Global Financial Crisis – but much harder to demonstrate formally.
That is the key feature of this paper. Whereas conventional models ignoring housing risk typically predict that housing affordability can continue to worsen, our work demonstrates that even modest shocks to the economy – for example to household income – can stabilise affordability, but at the cost of major house market crashes when house prices are high.
The occurrence of aggregate income cycles such as the Great Moderation since the early 1990s followed by the Global Financial Crisis of 2007-08 additionally amplify the cycles in affordability and house prices. But market crashes are hardly an optimal policy response to improving affordability, given the wider effects on the economy. If reliance on supply expansion is inadequate, then this implies the need for more integrated housing policies, where housing issues play a wider role in macroeconomic policies.
Endogenous UK Housing Cycles and the Risk Premium: Understanding the Next Housing Crisis – Geoffrey Meen, Alexander Mihailov and Yehui Wang, University of Reading