Perfectly efficient? Part 1

August 21, 2006 | Homeowners, Inflation, Interest Rates, Prices

Amid all the journalistic fluff and lather about housing bubbles, signifying nothing, trust the Economist to lay out the whole story in under a thousand words, throwing in a primer on house pricing along the way:

DURING the past decade Britain’s housing market has had its most sustained boom in post-war history. Between 1997 and 2006, house prices rose by 175%, one of the biggest increases among developed economies (see first chart).


At its peak, in 2002 and 2003, house prices were soaring by over 20% a year.

A bubble had emerged, as Gordon Brown, the chancellor of the exchequer, acknowledged last autumn.


Had a bubble emerged? A good definition of an economic bubble is:

An economic bubble occurs when speculation in a commodity causes the price to increase, thus producing more speculation. The price of the good then reaches absurd levels and the bubble is usually followed by a sudden drop in prices, known as a crash.

Economic bubbles are generally considered to be bad things because they cause misallocation of resources into non-productive uses. In addition, the crash which follows an economic bubble can destroy a large amount of wealth and cause continuing economic malaise as was the case of the Great Depression in the 1930s and Japan in the 1990s.

For a bubble, therefore, we need speculation unrelated to consumption demand. Bubbles arise when people buy solely because they anticipate selling to a bigger fool.


If I’m this foolish …


… then he’ll be more foolish!

That doesn’t always work, for timing is all:

In 2005 residential-property sales in England fell below a million for the first time since 1996. House prices stopped rising for several months.

On past form the slowdown seemed likely to presage a long slump. The boom was the fourth since the early 1970s, and on each of the three previous occasions a bust had followed. At the end of 2005, according to the OECD, house prices were about 30% above their trend level.

Unique among asset classes, housing is seldom purchased by pure speculators. Consider the five types of home buyers:


5 types of home buyers

1. Consumers. People who buy a house (for our purposes, condos and any other form of occupant ownership count as houses) intending to live there. Even today, over 90% of all buyers.

2. Indulgers. People who have one house and buy a second place for use on weekdays (pied a terre), weekends (the nearby vacation), or a summer (the resort home).

3. Investor landlords. People who buy because they believe they can make a long-term profit renting the house. They make this move because they can buy cheaply, or can renovate the property, or see a niche they can fill as a business.

4. Capital importers. People, often non-Americans, with excess capital who believe that moving it into property in the USA is a safe thing to do. The urban cores of at least Miami, New York, San Francisco and Honolulu are strongly influenced and periodically driven by capital importers. (I should post about this some day, shouldn’t I?)

5. Speculators. People who buy solely in anticipation of flipping, usually in the short term.


Pull up a truck full of money and we can help you!

Of these five types, only one — pure speculators — are active in a true economic bubble; the others retreat to the sidelines. Very importantly, investor landlords, and even some capital importers, will stay out of markets when speculators are ruling the roost, and enter when those same speculators have to sell. Perhaps that explains why England then experienced a curious rebound effect:


A very curious effect indeed.

The market staged an unexpected recovery, however. Property transactions picked up. Monthly mortgage approvals for house purchase, which had slumped to 76,000 in November 2004, recovered to 117,000 in May of 2006. House prices have also perked up. Fionnuala Earley, chief economist at Nationwide Building Society, now expects house prices to rise by around 5% in 2006.

Prices above a trend line could be an economic bubble, or they could be a systemic shift.

The housing market appears to have stabilised at much higher valuations than were previously reckoned possible. A common measure of affordability is the ratio of average house prices to average earnings, since income must ultimately pay for the acquisition of a property financed with a loan.

There, in a nutshell, is the fundamental lemma of urban land value: property is worth what people pay for it, and they pay what they have to spend, which means what they are earning.

Looked at this way, homes are even more overvalued than they were at the peak of the boom in the late 1980s: the ratio stands at 6.0, compared with 5.2 in the third quarter of 1989.

Let’s make this crystal clear.


I foresee big profits.

A typical English family making £50,000 annually would be living in a home worth £300,000, up from £260,000 fifteen years earlier. That means the family’s paying 15% more for housing (6.0/5.2), right?


Well, no, because in that interval, interest rates have fallen:

When homebuyers work out whether a property is affordable or not, the cost of servicing a new mortgage as a chunk of take-home pay is more salient.

It’s not just that external rates have fallen. Rate spreads have compressed.

Homebuyers have also benefited from greater competition in the market. This has whittled down the margin between banks’ deposit and home-loan rates, so lowering the cost of mortgages.

Lower spread, lower cost. These are systemic shifts, which translate into enduring readjustment.

On a cost-to-income basis, valuations are also stretched, but homes are still considerably more affordable than they were at the end of the 1980s (see second chart).


Yes, that’s the right chart. Indeed, English households are now paying a lower share of their income than they were fifteen years earlier.


The decline in borrowing costs over the past decade goes a long way to explaining why house prices have proven so irrepressible.

People can buy more house — so they do.

However, there’s a downside:

[Continued tomorrow in Part 2.]