Bursting the bubble: a structural rule for housing

A simple plan for bringing UK housing prices to sustainable levels
Not for the feint of heart, or shallow pocket

Not for the feint of heart, or shallow pocket

The unstoppable rise in house prices over the past decade or two has been, along with stagnant real incomes, the most important contributor to the decline in prosperity and well-being among the middle classes in Western countries. The sheer level of absurdity of house prices in cities like London and New York simply beggars belief, and has forced residents to either dish out a larger share of their incomes on rents and mortgage payments, or accept compromises such as shared accommodation, distance, or simply bad quality housing. Worse still is that the housing markets in some of these global cities appear to defy economic logic, rising even when their national economies stagnate. And it’s not just the big “alpha cities” that are feeling the pinch: cities in Canada, Australia and Brazil among many other cities in both the developed and the emerging world have also seen meteoric rises in prices over the last two decades.

Understanding London’s urban crisis

London is perhaps the most representative city of the modern housing bubble for various reasons. It is one of the few unquestionable alpha cities, as well as being the economic and political center of the nation. This alone has created tremendous demand for housing that in recent years has been most strongly felt from abroad (particularly for more high-end real estate). Despite this, the city is constrained in its capacity to build high and afar: in the former case, due to height-restrictions in many central parts of the city and in the latter case, by the Green Belt which sets an outer limit for the extent of urban sprawl. Lastly, the city is unique among those of its size in the sheer amount of single-family housing available in its central area. In contrast to cities like New York or Paris, where most living space in the central area is composed of multi-family apartment blocks or high-rises, entire neighborhoods in Central London are formed of neat terraced houses that give the city its unique Victorian and Georgian flair.

It is clear, therefore, that there is a structural mismatch between ever-growing demand and the supply of housing, which is scarce. According to a recent report by the, there is apparently a shortage of 1.5 million houses in England, many of which would be best built in London and the South-East where prices are highest (the average dwelling in London currently costs an insane £400,000 despite the fact that new builds are the smallest in Europe). Much of this shortage is due to the fact that public spending on public (a.k.a council) housing collapsed during the Thatcher administration and has never recovered. This is mostly because, as part of her drive to privatize the housing market, local councils (who in the UK are largely responsible for public housing) were prohibited from using the profits of selling off their existing public housing stocks in order to build more. No surprise the bubble began building.

Since then, housing has sadly never become a priority for public policymaking, either under Labour or Conservative governments who have preferred to let market logic dictate its terms. If anything, the Thatcherite logic of spurring home ownership (as evidenced by the preposterous “Help to Buy” scheme launched recently) is still the driving force of housing policy, widening the mismatch even more between supply and demand. Only a fool would dream of a major change in policy now which means the whole point of my proposal is moot. But that doesn’t mean it doesn’t have some merit.

The structural rule

The first step to solving the housing crisis is to establish a structural rule on home-building. Up until now, structural rules in economics have been mostly used for fiscal purposes: the Chileans, for example, pioneered such a mechanism by fixing their budget limit on the basis of historic growth and copper price trends. During good times, either when the economy was doing better than normal or when copper prices were higher, the rule would act as a cap on overspending. However, during bad times, the rule would work the other way and allow extra spending which would hopefully have a positive countercyclical effect. Not surprisingly, Chile is quite possibly one of the most fiscally responsible economies not just in Latin America but in the world: at less than 12%, their gross debt level is only slightly higher than many Western countries’ annual deficits were shortly after the crisis.

A structural rule for housing would work by forcing the government to spend on additional housing units when house prices rise above their historic trend and/or above the historic price-to-earnings ratio. I prefer the latter, as it guarantees that people will spend a similar proportion of their incomes on rent or mortgages regardless of whether incomes rise or fall. According to official statistics, the PE ratio for England stood at 6.7 in 2012, which means that houses cost that many times more than the average income (not long ago, in 1998 when the boom began, it was just 3.6). PE ratios are even more obscene in London, having jumped from 4.4 in 1997 to 8.6 by 2011. In certain boroughs such as Camden, Hammersmith & Fulham, Islington and Westminster, the PE ratio is in double digits, while in Kensington & Chelsea – one of the most lucrative real estate areas in the entire world – it’s an insane 27.8!

The structural rule could therefore target a fixed PE ratio, say 5, and commit to a pace of house building commensurate with reaching and then keeping that ratio: if the ratio rises any given month, then housing starts are pushed up until the ratio is stabilized again. If the ratio falls, then there is leeway to use some of the surplus investment to be used for other categories of capital expenditure, or to be saved for future use. Of course, the structural housing rule should ideally be combined with other policies to keep prices down. For example, by forbidding the marketing of real estate abroad, eliminating height restrictions (do we really need that view of St. Paul’s?), slapping a major tax on mostly unoccupied residencies (like the Kensington townhouses where the global super-rich spend just a few weeks a year), and eliminating facilities for owning second homes such as buy-to-rent schemes (it’s telling that this piece in the right-wing Telegraph begins with a case for dispelling any moral and either considerations for such purchases). After all, the more housing is seen as an investment, the more that markets will drive their prices up.

How to pay for this?

Ultimately, the success of a structural housing rule depends on whether or not it’s financially feasible. In this sense, I am hardly qualified to offer anything but a very crude estimate of its sustainability. First you need to quantify demand: a recent study by Shelter, a UK think tank, estimated that the country requires approximately 250,000 new homes a year (other estimates have proposed even higher numbers). This is a good rule of thumb to base the structural housing rule on once the PE ratio is stabilized, say, over a two decade period. Such a timeframe would allow house prices to converge towards trend levels while still rising in nominal terms so as to not to piss off landowning constituents (just under two-third of households in Britain own their home), and to protect those who are legitimate first-time buyers from seeing their mortgages go underwater if prices fall.

This creates jobs

This creates jobs

So let’s initially assume that a quarter million homes are needed per year. Part of this will come from private sector builds, another by increasing public spending on housing, and another through efficiency gains on existing expenditure. One can assume that in the medium- and longer-run, a gradual fall in housing costs would help alleviate the need for spending on housing benefits as more people would find it affordable to pay their housing costs in full. According to budget figures, housing benefits and rent rebates came in at £22.4bn in 2011/12. Assuming the cost of building a standard-quality 100 sq/m dwelling in London amounts to around £100,000 (data from this guide), that’s 56,000 new homes a year that could be built if the housing benefit was gradually cut by one-fourth and the proceeds used for new builds. This is not too crazy an idea. In 1987, amounted to just £3.8bn, which was far less as a share of GDP than it is now (about 40% less).

Likewise, raising the upper bands of council tax to levels that reflect the true price of the property would also provide an extra handful. In Kensington & Chelsea, the upper band of council tax on a house is £2,143.3 a year for all houses over £320,000 (in 1991 prices). The problem is that such a figure is not significantly above the borough’s average, which means that multi-million pound properties pay a minuscule amount in council tax relative to their value. Because the value of the council tax bands varies much less than the house price ranges in those bands, it is an incredibly regressive tax, one that is in urgent need for reform into a more progressive mechanism if only for reasons of fairness. But let’s assume that this can add an extra 10% in revenues, which is equivalent to £2.2bn (total council tax revenues were £22.4bn in 2011/12). This is over two-thirds of what councils already spend on housing, £3.3bn, and could net another 24,000 builds. We’re at 78,000 now merely on efficiency gains.

As for outright spending, just 0.5% of GDP represents about £12.2bn; another 122,000 homes for a grand total of 200,000 just on the public sector side. Currently, the private sector provides some 85,000 new builds a year so we’ve passed the quarter-million threshold by some margin. Reducing regulatory bottlenecks for private developers and self-builders could also help boost their contribution, say to 125,000 (half of what’s needed). Which means the government would actually get away with supplying just 47,000 new builds from extra spending. Yes people, keeping the housing market stable would cost just 0.2% of GDP (with Keynesian multipliers included, even less). A faster rate of home-building before the stabilization point is reached would not be significantly higher than this; say the original 0.5% of GDP at the most, resulting in a frothy total of 325,000 builds.

An end to the madness

My proposal might sound a bit wish-washy, and the math may well be far more complicated than in my simplistic assumptions. But my point is that even a city like London need not suffer needlessly from exorbitant housing costs. A housing bubble is a man-made fabrication, not an inevitability, and it stems from the reluctance of the political class to challenge the entrenched interests of existing homeowners who are the only ones who stand to benefit, as well as in a misguided faith that market logic should dictate the fortunes of the housing sector. Worse still, is that it lays bare one of the most blatant contradictions of free-market advocates: that in their drive to leave housing to the market, they end up spending more in welfare in order to avoid a social breakdown (for every £1 of public subsidy spent on housebuilding, £5 is spent on alleviating housing costs, compared to a ratio of 1:1 in 1979). It doesn’t take a genius to figure out that this is a blatant extraction of taxpayer wealth in order to finance the social costs of maintaining the privileges of homeowners (particularly the rich whose property prices rise faster).

When will this insanity end? Only until we have politicians who see housing not simply as investments for the global elite to park their wealth, but as an actual social necessity for their middle- and working-class constituents will one of the biggest economic calamities inflicted on Western world can be decisively resolved. But don’t hold your breath, people.

Update: I will soon make a follow up post with a more rigorous mathematical evaluation of this idea.

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  1. Pingback: Bursting the bubble: the math behind the housing crisis solution | disequilibrium.org

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