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The housing boom will end, but how?

By Martin Wolf

Published: November 24 2006 02:00 | Last updated: November 24 2006 02:00

For the British, houses are as much gold mines as mere dwellings. Over the past 10 years, real house prices have doubled, while real disposable incomes have risen only 29 per cent. Ratios of house prices to incomes and rents have, as a result, reached all-time highs. Housing made up as much as 53 per cent of the total wealth of UK households in 2005, against 39 per cent a decade before. Can this last? No. Will it end with a bang or a whimper? That is indeed the big question.

Given this, what are we to make of a prediction that "sharp falls in real house prices may not come for a year or so, but come they probably will" (emphasis in original)? We should take it seriously, particularly since David Miles of Morgan Stanley, the lead author of the report in question ("UK Housing: how did we get here?"), is an erstwhile adviser on housing finance to Gordon Brown.

The study estimates a simple model in which prices depend on average incomes per head, the size of the population and the real cost of home ownership. The last, in turn, depends on real house prices, interest rates and other housing costs (such as depreciation, repairs, insurance and taxes). But, above all, it also depends on expected changes in house prices. The more house prices are expected to rise, the cheaper the effective purchase price also becomes.

This last point is central. If people's expectations of future price increases are affected by their recent experience prices will tend to overshoot fundamentals: this is just how bubbles form. In the Morgan Stanley analysis, people's expectations of future price rises are affected by both recent experience and the belief that there is some long-run average rate of house price inflation towards which the current rate will converge.

The analysis then gives two interesting results. First, it does explain the doubling of real prices over the past decade. Second, changes in expected prices explain a very large proportion of those increases.

In one specification, higher incomes per head would have generated a 28 percentage point real price rise on their own, rising population would have generated a nine percentage point rise and the reduction in real interest rates would have generated a further 14 percentage point rise. All the rest (62 percentage points) was due to changes in expected prices.

But a specification that includes the increase in supply of new housing reduces the impact of price expectations to 39 percentage points.

None the less, the conclusion is clear: what we are seeing is, in significant measure, an overshoot of fundamentals, in which house prices are being lifted by their own bootstraps. In other words, people now buy houses at historically unprecedented prices because experience has taught them to expect those prices to go ever higher. This analysis then depends on the assumption that expectations are "adaptive": instead of expecting prices to fall when they have risen, people expect them to rise still further.

An implication of this approach is that the amplification of price movements works in both directions. At some point the real cost of housing will bring price appreciation down. When that happens adaptive expectations will go into reverse and so generate price falls.

The study's conclusions then are that declines in prices are plausible. But predicting timing is impossible since that depends on precisely how expectations are formed, which, inevitably, we do not know.

So how disastrous would such falls be? On this the study is sanguine. It argues that the impact on consumption is modest, in both directions, because higher prices make purchasers worse off to the same extent as they make owners better off.

The big point is that higher house prices cannot make society as a whole better off. They merely redistribute income from the young to the old, which is socially destructive. If, in addition, there is an element of overshooting, that will prove particularly costly to those who turn out, retrospectively, to have bought at the peak. For these hapless people, it would be far better if price overshooting had never happened.

The model is not invulnerable to criticism. It is entirely in real (that is, inflation-adjusted), rather than nominal, terms. Yet lower nominal interest rates make purchasing appear more affordable, because the annual cash outlay falls. Affordability, thus measured, does remain below levels reached in the early 1990s, when interest rates soared and house prices crashed. That is surely one reason for higher demand and so prices.

The implication of this is that prices may stay high. But it also means that purchasers may have contracted to pay a far higher real amount than they realise. If so, this will prove a painful long-term burden upon them.

The question, above all, is not whether the boom will end, since it must, but how. Will real prices stabilise, or fall? I suspect that the answer will indeed be the latter. But, as the study notes, nobody can possibly know when or by how much.

:)

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......None the less, the conclusion is clear: what we are seeing is, in significant measure, an overshoot of fundamentals, in which house prices are being lifted by their own bootstraps. In other words, people now buy houses at historically unprecedented prices because experience has taught them to expect those prices to go ever higher. This analysis then depends on the assumption that expectations are "adaptive": instead of expecting prices to fall when they have risen, people expect them to rise still further......

....The question, above all, is not whether the boom will end, since it must, but how. Will real prices stabilise, or fall? I suspect that the answer will indeed be the latter. But, as the study notes, nobody can possibly know when or by how much.

:mellow:

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The big point is that higher house prices cannot make society as a whole better off. They merely redistribute income from the young to the old, which is socially destructive. If, in addition, there is an element of overshooting, that will prove particularly costly to those who turn out, retrospectively, to have bought at the peak. For these hapless people, it would be far better if price overshooting had never happened.

love it!

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Given this, what are we to make of a prediction that "sharp falls in real house prices may not come for a year or so, but come they probably will" (emphasis in original)? We should take it seriously, particularly since David Miles of Morgan Stanley, the lead author of the report in question ("UK Housing: how did we get here?"), is an erstwhile adviser on housing finance to Gordon Brown.

Now that is a timeframe I can work with........ :):)B)

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