A UK, housing-industry lobby group, the Royal Institution for Chartered Surveyors, recently called for the Bank of England to try to ‘cap’ annual house price increases at 5%. This is in the context of evidence that house prices are accelerating again in the UK, despite measures of turnover remaining relatively subdued, and comments by Mark Carney, Bank of England Governor, that the Bank might contemplate interest rate rises if a housing boom got going.
‘Capping’ annual house price inflation would not be a good idea. Houses perform several functions, and the demand and supply for these functions will likely vary from time to time, in ways that could mean that increases or decreases far greater than 5% in annual terms may be necessary and desirable from the point of view of society as a whole.
One obvious thing houses do is offer what economists would call ‘housing services’, what the average punter in the ‘Dog and Duck’ would call shelter.: all that is nice about living under a roof. (It’s dry, harder for people to steal your stuff, and you have more privacy than on the street). Supposing the supply of shelter roughly fixed, the price of shelter services will rise and fall with demand. Some factors determining the rise and fall in demand for shelter should play out slowly – like changes in the average size of households, or changes in net migration. (In the UK the former has shrunk with single parentage and divorce, putting pressure on houses, and net migration has been strong for ten years or so). But some such factors might move quite quickly, in line with changes in disposable income, or expected disposable income. These dived at the start of the recession, for example. If we could establish that even these fast-moving influences on the fundamental price of housing services would not change prices by more than 5% in a year, then perhaps there would be some sense in the cap the RICS were calling for. But we can’t possibly claim this.
Houses don’t only offer shelter. They are also an asset. Since they usually last, if built well, and can be re-sold, they provide a way to store wealth. One key factor determining asset prices is the price of consumption today relative tomorrow, or the real interest rate. Once again, some of the factors determining the real rate move only slowly over time, but some of them moving very quickly. Demographics affect the real rate, and, social catastrophes like wars or plagues aside, move slowly. Young people are trying to bring forward consumption, spending out of income they don’t have. The middle-aged are saving for when they can no longer work. The old are running down their savings, unable to work or tired of it. More young people puts upward pressure on real rates to encourage those that can to save and lend it to them. (Etc). Another key factor determining real rates though is beliefs about the trajectory of income over the future. If we all discovered that we were going to get some huge windfall in the future, we’d try to spend some of that now by borrowing, pushing up real rates. When real rates go up the value of an assets falls. News about the future, or changes in beliefs about the future, can materialise quickly and have very large effects on the ideal price for houses. In the face of such changes, caps don’t make sense, no more so than capping the price of oranges relative to apples. Of course, if the authorities had better insight into the trajectory of national incomes than those investing in houses, then there might be justification to try to limit house price movements accordingly, to bring about the price people would strike if they knew as much about their own futures as the Government, but even then the ideal price could move a lot more in a given year than 5%. And after 20 years in the Bank of England, watching the last housing boom and bust play out alongside our forecasts, I see no reason why we should think that the authorities have this special insight.
Houses do other things too. They hedge people against fluctuations in rents. (If rents double shortly after I retire, but I own a house, what I can buy out of my pension is protected. If I don’t own a house, I can afford much less food after paying for my housing). And houses protect people against inflation risk. (For example,
I doubt the component of house prices that is related to hedging fluctuations in rents varies that much. But inflation (and deflation) risk could.
There is plenty of research showing that volatility in house prices may be bad. One line of reasoning in particular is that house prices amplify booms and busts. Housing serves as collateral for loans. In a boom, the demand for borrowing may rise anyhow, but rise even more because a rise in house prices increases the amount of collateral households have, and this reduces the cost of borrowing because lenders are more confident of selling the security and recovering the loan if the household defaults. But these models don’t give us enough to argue for a quantitative cap on house price changes from one year to the next. I expect and hope that the Government and the Bank ignore the RICS’ suggestion.