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Issue 16/18 November 2009

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Today’s Issue Includes:

1) Housing market case study: Why are UK house prices rising? By Nigel Tree.

nigelcropforezineThe Background

According to the Nationwide, house prices were 2.0% higher in October 2009 than they were a year earlier, to give an average house price of £162,038. This was the first annual rise in house prices for nineteen months. In fact, house prices, according to the Nationwide, have now risen for six consecutive months.

The recent trend can be seen in the graphic below.


Why would we expect house prices to be falling?

We are currently going through our worse recession since the 1930s which is putting a lot of negative pressure on demand. So we would expect a fall in demand for houses which would put downward pressure on house prices.

What factors would we expect to be contributing to such a fall in demand?

  • Unemployment has now risen to 2.47 million. This actual increase, added to the fear of unemployment for many who remain in work, would tend to depress demand.

  • Average earnings are also falling. In the three months to August 2009 average earnings excluding bonuses rose by 1.9%, which is the lowest rate of increase since comparable records began in 2001.

  • Costs of mortgage borrowing are high. Although the Bank of England’s base rate is at a record low of 0.5%, mortgage interest rates are not following suit. According to the estate agents group, Countrywide, the average rate of interest for mortgage applicants is 5.13%. On top of this, the Building Societies Association warned last week that mortgage interest rates may have to rise further due to more onerous regulation on lending coupled with a “battle for savers’ deposits” as institutions compete for a limited amount of savings.

  • Increased deposits also have to be added to higher borrowing costs. During the previous housing boom it was not unusual to see 100% of a house’s value offered by the mortgage lenders, meaning no deposit was required at all. Currently, following the meltdown in financial markets, deposits of around one-quarter of house value are being sought. This makes it extremely difficult for first-time buyers to get on the housing ladder.

The other possible cause of a potential fall in house prices could come from an expansion of the supply of houses. Given the current climate new house building has all but dwindled away. However, when large numbers of home owners default on their loans, this can lead to repossession of houses followed by their placement on the open market by the mortgage lenders. But, this has not happened to the degree that it has in previous “housing busts”. In fact, the Council of Mortgage Lenders has just reduced its forecasts for the number of repossessions this year from an initial figure of 75,000 down to 48,000. There were 12,700 properties repossessed in the first quarter of 2009, compared with only 11,700 in the third quarter.

There are two reasons for this low level of repossessions. Firstly, the state of mortgage lenders’ balance sheets has made them reluctant to take losses onto their books, which would happen if they repossessed a property, and so they have been surprisingly content to allow arrears to build up on mortgage repayments. Secondly, the government has been putting a lot of moral pressure on them not to foreclose.

So there are good reasons for a student of economics to have expected that house prices would be falling, due to a combination of demand and supply pressures. However, this is not what is currently happening.

So why are house prices rising?

Perversely it is due to a combination of some recent increase in demand coupled with a shortage of supply.

On the demand side, some investors are calling the bottom of the market, and are taking the opportunity of buying up fairly cheap property. In fact, the buy-to-let mortgage market grew in the third quarter of 2009 for the first time in two years, with a 10% increase over the previous quarter.

Added to this, the government increase in the zero rate threshold for stamp duty to £175,000 has made it somewhat cheaper for those trying to get on the housing ladder. In fact, one-third of first-time buyers have escaped stamp duty in October.

On the supply side, many potential sellers are just sitting tight and not putting their houses on the market. This has outweighed the number of repossessions coming back onto the market plus the number of new houses being completed. Home owners who might have been ready to trade-up, now find that they have insufficient equity in their houses to do so. With the requirement for increased deposits coupled with lower multiples of earnings to house value on offer from mortgage lenders, many owners are having to shelve their plans to move ‘up-market’. Certainly, in the north-east of England, higher-value homes are just not moving in market terms, and are being taken off the market by owners reluctant to compromise on their selling price.

Together, these supply and demand forces are currently working together to cause the marginal upturn in house prices which we have seen over recent months.

Conclusion: What of the future?

According to Martin Gahbauer, Chief Economist of the Nationwide, writing at the end of October: “Given the poor labour market situation implied by the economy’s ongoing weakness, it is difficult to imagine the housing market returning to the buoyant levels of activity and price inflation that prevailed earlier in the decade.”

Most economists believe that we may not yet have seen the bottom of the housing market slump. The reduced threshold for stamp duty will be removed in the new year, which will take away one impetus to demand. At the same time VAT will be put back up to 17.5% from its temporary reduction to 15.0%. This will put up prices in general for consumers who will also be affected in their pocket in other ways too. For example, the price of oil is currently rising which will feed through into higher energy and transport bills.

But perhaps the major impact will follow from the urgent need to address the government’s financial position next year – whichever party is in power! We can expect higher taxes and restrained spending which will put additional pressure on consumer disposable income.

All in all the future does not look bright for the UK housing market as most economists currently agree. But then, given the fact that the housing market has been so difficult to predict – what do they know?


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Erratum: In the Economic Efficiency article in Issue 15 we apologise for an error in the second diagram showing an allocatively efficient firm. It should show AR = MC instead of AR = AC.


2) Household Saving by Nigel Tree


In the Bank of England’s Quarterly Bulletin for the third quarter of 2009, Stuart Berry, Richard Williams and Matthew Waldron have produced a very interesting article on UK household saving. I will try to summarise some of the main findings.

Household consumption accounts for around two thirds of aggregate spending in the UK economy so it is obviously vitally important for the economy as to the balance between spending and saving by consumers. The authors note that the share of their income which households saved fell steadily over the period between 1995 and 2007. This can be seen in Chart 1.


As a result of the recession UK output has fallen by about 5.5% over the past year which will have altered households’ balances between consumption and saving. In fact, by the end of 2008 and early 2009 the saving ratio started to pick up, as can be seen in Chart 1.

What factors might affect households’ spending and saving decisions?

  • Permanent Income: According to Friedman households base their current spending decision on their “permanent incomes”, which is the income they would expect to earn over their whole lifetime. From this one would expect that during an economic downturn current incomes will temporarily fall below future incomes, and households will run down past savings to maintain current consumption.

  • Interest rates: A higher real interest rate encourages consumer to put some consumption spending on hold as the real return on savings is increasing, and vice versa.

  • Credit conditions: If credit becomes more difficult to get or more expensive we would expect borrowing and spending to be lower and thus aggregate saving to rise.

  • Uncertainty: Increases in uncertainty such as the fear of losing a job are likely to lead to an increase in precautionary saving.

  • Wealth: A rise in households’ financial wealth, say from an increase in equity prices, would encourage them to spend more and save less. However, about half of household financial assets are held in pension funds and life insurance and are not really visible to households. Some studies suggest that if wealth increases by £1 consumption increases by around 4 to 6 pence per year.

  • Government and corporate saving: Saving by companies and the government should eventually flow back to households in the form of lower taxes or higher dividends. The theory of Ricardian equivalence suggests that households view their own saving and government saving as perfect substitutes. However, the authors argue that in practice while government and corporate saving are likely to be important influences on household saving, they are likely to be imperfect substitutes.

  • Inflation: Inflation will erode household assets such as bank deposits. Since higher inflation is usually coupled with higher nominal interest rates, households will save these higher interest receipts in order to protect the real value of their wealth.

  • Demographics: The life-cycle/permanent income model suggests that household saving will alter over a lifetime. There will be greater borrowing when young at a time of lower incomes, and increased saving for retirement in the middle years when income is higher. On retirement savings will be rundown gradually. Therefore changes in the age structure of the population over time can affect saving.

Why did household saving fall between the mid-1990s and 2007?

The household saving ratio fell from around 10% to around 2% over this period. Factors which worked to pull down on household saving over this period were:

  • UK long-term real interest rates fell by over 2 percentage points during this period and economic models suggest that this may have caused a fall of around 4 percentage points in the saving ratio.

  • This period saw macroeconomic stability and falling unemployment which will have reduced precautionary savings.

  • Cheaper and easier access to credit may have brought consumption forward and reduced aggregate spending.

  • Rising house prices may have encouraged lower saving by providing more collateral against which to borrow.

Factors which worked to push up household saving were:

  • Demographics: The number of middle-aged households were rising and we would expect them to save more.

  • Employers boosted their pension contributions and without this the saving ratio would have fallen even more steeply.


The saving ratio has recently risen

Why have savings recently risen?

The authors argue that this mostly represents a reversal of the factors outlined above which have pushed down saving in the past. These include:

  • Tighter credit conditions: The financial crisis has made banks less willing to lend and thus some households may be less willing to spend and will save more.

  • Increased job uncertainty: A rise in the unemployment rate of 2.5% over the past two years will lead to greater precautionary saving.

  • Falling asset prices: Net financial wealth fell by around a quarter in the two years to 2009 Q1, and this decline in wealth may lead households to look to increase their savings to rebuild their personal balance sheet.

  • Reassessment of debt levels: Households may seek to increase saving to repay debt as they worry about changes in asset prices or financing costs.

  • Higher government borrowing: In the August 2009 Inflation Report, the MPC noted that households might feel the need to save more to meet an expected higher tax burden, as the government has to rein in its fiscal position in the years ahead.

  • Lower expected future income: If households have revised down their expectations of future income relative to current income, this could lead them to save more. The authors note that a proxy measure of permanent income has fallen sharply since the start of the financial crisis suggesting that households will have revised downwards their estimates of their permanent income.

  • Monetary policy: Over the last year monetary policy has been providing a stimulus to the economy which should act to smooth any adjustment in household saving. Low interest rates should persuade households to spend and thus monetary policy should cushion the extent to which saving may rise in the near term.

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