The UK Housing Market - Essay Example

?Business Economics Q1 Discuss the reasons for the problems encountered in the market for housing over recent years. Analyze and evaluate the measures taken by both the industry and the government of a country of your choice to counter these problems, using specific examples to illustrate your arguments wherever possible. Introduction The very recent outburst of the housing price bubble in the most advanced and developed economies of the world has raised in serious concerns about the management of the macroeconomic tools, measures to combat the inflationary pressures especially by the public authorities, as that led to a financial crisis, and the consequences of the financial crisis had to be faced by the global financial economy. (Hay, 2009, p. 461) The bubble formed by the housing price was the initiator of the general global economic crisis brought over to the whole world. What initiated the crisis was the bursting of the house price bubble in the United States and the problem was magnified by the aggressive mortgage lending prices. The housing market or the real estate market comprises of several differentiated markets as the owner occupied market, rental housing market, urban business properties market that is the factories, shops and the offices, the agricultural land markets and the recreational properties. There are five main reasons that are held responsible for the house price bubbles; they are low interest rates, development of new and innovative financial products which facilitated the availability of the credit, the tax treatment was also in favor of the debt-financed and owner-occupied housing; shortage in the supply of land in the attractive urban areas, increase in the purchase of houses as a rental property or for speculative purposes. (Muller, Almy, Engelschalk, 2009, pp. 17-20; UK Economy in ‘Worst Crisis’ in 60 years, 2008) The Housing market Crash The UK housing market The real house prices have grown stronger over the past years, which have been volatile accompanied by macroeconomic fluctuations. The UK Housing market has gone through significant turbulence since the early 1980. In the period between 1982-1989, the market experienced a rapid rise in the housing prices, but meanwhile the housing prices showed a downward trend during the period 1990-1992 resulting in house price inflation. Accruing to the high economic growth in the years 1992 and 1993, the housing market in UK witnessed an increase in the average house price inflation, which originated in London and the South East region, which had a rippling down effect towards the north. The UK housing markets are the result of the personal sector wealth proportion, which was invested in the owner occupied dwellings. The UK owner occupied dwellings accounted for 20 percent in 1960, which increased to 40 percent in 1990s. Highest owner- occupation rates and the lowest private renting characterize UK. The main reason which drove the financial turbulence in the housing market in 1980s are the liberalization of the financial markets and the policy of ‘Right to Buy’ which ensured the transformation of the population from the rented house to the private own occupied house. The increase in the competition among the lenders resulted in the fact that the borrowers get loans. This resulted in an increase in the household sector mortgage indebtedness from 25 percent in 1980 to 75 percent in 1992. The average mortgage advance reached its highest 60.1 percent in the year 1986, and thereby remained at a steady 58 percent for the rest of the 1980s. The house price inflation was fueled by the amalgamation of factors like increased in demand for housing, rising incomes, and an increases in the competition to supply mortgage lending. (Figueira, Glen, Nellis, 2005, p. 1756; UK house prices drop like a rock, 2008) The reason behind the crash The main reason behind the UK housing crash was it’s serendipitously stumbling upon the economic growth trajectories, which were mainly consumer-led and private debt financed in the early 1990s. Both this trajectories were sustained till then by the low interest rates which made it possible to access the housing market, as it became more affordable accruing to the low interest rates. The sustained low interest rates aided the development of the housing price bubble. The bubble once formed was sustained due to the low interest rates. But the low interest rates were not the only reason which kept the bubble inflated, the highly securitized and the liberal character of the mortgage market was also responsible for it. In a scenario like this the bank and the building societies acted efficiently as financial intermediaries which started re-packaging new loans as mortgage backed securities for institutional investors like pension funds. As a result of the high income generated by the transaction fees due to the interest spread loans between the deposits and the loans, they went on inventing innovative ways to offer new mortgage instruments to potential borrowers. This fueled the propensity to consume among the borrowers who were ready to let go the equity created upon their property. But the high levels of mortgage debt relative to GDP, early financing of mortgages and mortgages securitization, wide spread of home ownership were the result of the policies taken up to combat the disinflation in the 1990, these all were the measures taken up to increase the aggregate demand of the country.(Hay, 2009, p. 462; Financial crises: Lessons from the history, 2007) UK witnessed a house price boom in the late 1980s and a longer period of house price inflation as a result of the forcible ejection of UK from the European Exchange Mechanism on Black Wednesday in September 1992. The prices of the houses has always shown a northward trend but it is only twice in the last 20 years that is in the years 1990 and 1994 the price of the houses have fallen, apart from those two years the house price in Europe has experienced an uninterrupted rise in its prices from the year 1995 to 2003 and again during the period between 2005-5007. The house prices in UK have proven to be downwardly sticky. In November 2006 the average house price in UK reached ?200000 when the average annual earnings were increasing at an annual rate of 11 per cent. The wealth effect related with the house price inflation was alike to the three quarters of before tax annual average earnings which proved to be an irresistible incentive for people to release equity to fuel consumption which accounted for 4 percent to 6 percent of the GDP. At June 2008 the average price of the house had fallen by 8.9 percent according to Halifax house price index. Therefore in the place of a net wealth effect of 75 percent of average earnings, the equity of the average wage earner had fallen. The effect of it was worst for the new entrants in the property market and the people who have used up all their equity in building up their property during the period of the housing boom. This proved to be fatal at the time of rising commodity prices and energy prices. Hence there was a lack of additional demand in the lending market. The commercial lenders were reluctant to initiate any new business and the few who were prepared to take up new business started demanding higher deposits, they also started charging higher arrangement fees and expected an increase in the interest rate premiums over the base rate. To sum it up there was a squeeze in both the supply side and the demand side on debt financed consumer spending in the UK recently. As quite well predicted by this scenario the lending structure that was secured under the property in the UK changed quite significantly as a result of the credit crunch. (Hay, 2009, pp. 468-471) The decision to join the Single European Currency made the government revise the remit of the Bank of England for its target of the inflation; it switched from a 2 and a half percent inflation rate to 2 percent inflation rate for CPI. But the CPI measures exclude the mortgage interest repayments and hence the chancellor was of the opinion to omit the housing price inflation in deterring the UK interest rates. Hence the interest rate in the UK have remained quite low since 2004, thereby contributing significantly in the formation of the house price bubbles which benefitted the government initially till it exploded in 2007. But the bank of England played an important role in controlling the rising price of the housing sectors by increasing the interest rates 5 times. This proved to be somewhat successful as the CPI fell to 1.8 percent by August 2007 from a peak of 3.1 percent in March 2007. Inspite of this result the inflationary pressure exceeded its earlier peak and no action was taken then. In the final quarter of 2007 and the first two quarters of 2008 the interest rates fell thrice which accelerated the inflationary pressures. The bank of England wanted to cushion the housing market, which was already on the edge of free fall. (Hay, 2009, p. 475) Another important factor that accounted for the creation of the housing bubble in the UK was the “pro-cyclical character of New Labor’s political economy” (Hay, 2009, p.472). The flexibility in the labor market acts a boon when the economy shows a growth as it allows demand to be equaled by capacity which in turn generates additional employment and prevent overheating. By the similar law when the demand falls in the domestic economy it is easier to lay of the surplus labors. At this moment at the specter of recession and falling demands those who were out of job failed to pay off their mortgage repayments and had to cut back their consumptions to bare essentials, thereby aggravating the situation all the more by contributing in the shortage of demand in the economy and a fall in housing market. (Hay, 2009, 472) The Impact of the Housing market Crash on the UK Economy The UK national debt to GDP ratio was 38 percent three years ago accounting for the lowest GDP rate, lower than the America as well. But as of now as predicted by the analysts that the public debt of the country would exceed the 100 percent of GDP the next three years. As a consequence of this the UK economy is at a vulnerable tipping point. The massive public indebtedness has occurred due to the Governments’ bailout of its banks and the business was adversely affected by the severe credit crunch in the economy. The huge stimulus spending has added massively to the deficit, but a close look of the situation from an optimistic view reveals that the economy has flat lined after it incurred a sharp contraction in the economic output during the peak of global financial crisis. (Filger, 2010) Economic policy taken by the Authority The continuous monthly meetings, which were held from October 2008 to March 2009, resulted in the lowering of the official base rate from 4.50 percent to 0.50 percent by the Bank of England, which was the lowest in the last 315 years of the bank. The rate has been kept fixed since then. With further no scope of cutting down the interest rates the Bank of England initiated an asset purchase or “quantitative easing (QE) program”. (Interest Rates and the Money Supply, 2011) The bank created money and used that in purchasing assets to stimulate the demand in the economy and thereby making an effort to meet its 2 percent inflation rate. But this process could not accelerate the money supply growth in the economy. The bank purchased ?75 billion assets using the money created by it which was increased to ?125 billion, ?175 billion, and ?200 billion in the months May 2009, August 2009 and November 2009 respectively. The Bank of England has purchased ?200 billion worth asserts in the current year, 99 percent of which were the gilts- the securities of the UK government. Despite this program taken up the Government the growth in the money supply of the economy has been slow but policy makers are of the opinion that the absence in the asset purchase program would had added to the problem all the more. This resulted in the 1.7 percent growth in the M4 excluding intermediate other financial corporations in the first quarter of 2011, showing an increase in the supply form as low as 0.8 percent in the first quarter of 2010. The notes and coins that were circulated outside the Bank of England witnessed an appreciation in their values by 3.1 percent till April 2011. (Interest Rates and the Money supply, 2011; Bank of England) Analysis The interest rates have been kept as low as 0.5 percent, which remains unchanged, the focus of the authority is on the monetary policy to boost the money supply in the economy. The QE taken up by the Bank of England has reduced the long-term cost of borrowing by a percentage point. Some commentators are of the opinion that although the QE has reduced the cost of borrowing it cannot be passed on as the business requiring the credit and the criteria for lending because of this has become rigorous. (Allen, 2010) The housing price fluctuations were the main reason, which caused cyclical divergences and the differences in the transmission of monetary policy impulses in UK. The flexibility in the mortgage financing and the constraints in the supply side of the housing market have been cited to be the major factors giving rise to the volatility in the prices of the house. The house price has risen sharply on an average compared to the rise in the local council tax revenues since 1997 as a result of not assessing the value of the property annually. This has resulted in the fall of effective council tax rate, which is the average tax ratio per dwelling to the respective average prices of the houses and a rise in the house price rates, which suggest the contribution of the council tax in the house price inflation (Escolani, 2000, p. 64). The initial sign of the housing market moving towards a peak was on February 2007, as a result of the subprime mortgage default in US. It was assumed to unravel the carry trade further leading to deleverage the credit boom. The UK credit market continued to grow inspite of the rising interest rates. There had been several reasons for the increase in the demand of the houses. UK witnessed a large influx of migrants from the Accession states, over 800000 who continue buying houses contributing to the formation of the price bubble. The condition of the credit market started deteriorating as a result of the increased gap between the base rate and the sterling LIBOR. The situation got all the more aggravated with a blow of the Bear Sterns Hedge funds in July 2007 resulting in a credit crunch in August 2007 implying that the housing market price would not rise any further (UK housing Market Crash and Depression Forecast 2007-2010, 2009). The UK’s property boom have been to a greater extent being caused by the group of “buy to let investors”, majority of this people were amateur landlords. (Crash in UK House prices Forecast for April 2008 as Buy to Let Investors sells on capital gains tax change, 2007). These investors had started banking upon the capital gain rather than on the rental income covering the costs, which led to the sharp fall in the UK house prices. (Crash in UK House prices Forecast for April 2008 as Buy to Let Investors sells on capital gains tax change, 2007). The housing stock exhibits a heterogeneous character, which is a mixture of old and new properties and of differing qualities. The establishment of new housing into the old system is a result of the new investment, which is the component of the fixed asset investment. And as for every fixed asset investment, the investment in the housing sector also faces the complexity of supply lags which is caused due to the constraints in the supply of land implying the inelastic nature in the supply of the new housing in the short run. The old stock housing indicates the investment flow from the past and hence the supply of old housing system is highly inelastic in nature. The inelasticity in the supply implies that economic rent can be earned in the short run as it is earned on land. The relationship between the value and the age of the property is non linear and complex in the housing sector unlike the business capital which depreciates overtime. Owing to the scarcity of the land the value of it will increase overtime. But while the desire for a new house is welcomed as against the 40 year old house but again comparing a 40 year old house with the 400 year old house, the desire for the 40 year old house will be more and there will arise the need of a building in new house- thus the combination of the diminishing factor of an old house and the desirability of a new house will complicate the valuations of the old house thus leading to uncertainty and instability. And the inelasticity in the house prices will shift the demand in the housing prices (Baddeley, 2005, pp. 9-10). The housing assets are not divisible and fungible; rather they are lumpy. The investment in the housing sector is durable consumption decision from the owner side. The adjustment and the transaction cost related with the housing tend is large and lumpy as well. The presence of the transaction cost associated with the housing sector generates threshold effect, which adds to the “jumpiness” and discontinuity in the housing demand relationships, and the investor in the housing market will economise on the transaction cost by the means of cutting down their number of housing transactions, which will constraints the liquidity of the housing assets. (Baddeley, 2005, pp. 9-10) These factor will affect the decision of buying and as the busing of new house will not be smooth and continuous function of the rate of return on housing. (Baddeley, 2005, pp. 9-10) Threshold effect the buyers by making them conscious about the right time to invest, the buyer will be more concerned about the favorable conditions of buying in terms of price, transaction costs and the fiscal conditions and this timing is very important and crucial for the market. The importance of timing and its irreversibility will imply that uncertainty will be an important aspect in the housing market. In the scenario of uncertainty the decisions are complete quick and costlessly reversible where uncertainty plays an important role as people changes their mind fast, similarly in an irreversible world where the future is known any ration thinker will take the right decision without being affecting by the uncertainty. Hence the coincidence of the uncertainty and the irreversibility becomes very significant at this moment. (Baddeley, 2005, p. 11) The irreversibility in the decision of housing rises when the transaction cost increases. The volatile market structure also provides an incentive for the first time house buyers to get an insight of the market which will affect their decision of buying the houses- that is the decision of buying a house will have an opportunity cost. Thus the uncertainty affects both the volume of the transaction as well as the time of the transaction in the market. When the economy is stable so is the market the first time buyer will have an incentive to invest in the housing market but before they do that they will “wait and see” which leads to the jumpiness and discontinuity in the buying and selling of the houses contributing to the housing market frenzies (Baddeley, 2005, p. 12). The problem of uncertainty adds on all the more by the imperfect and asymmetric information about the present and the past. There are a number of information asymmetries that is being encountered in the housing transaction like the buyers or the sellers have limited knowledge about the real intention of the other. The risk is exaggerated more in countries like England and Wales due to the long gap between the decisions to buy and sell a house and in the signing of the legal agreement. There are further limitations, which arises from the limited information about the financial background of the potential buyers and the borrowers. But overcoming information asymmetries becomes costly and adds to the lumpy transaction costs (Baddeley, 2005, p. 12). And a peculiar tendency in human being which has been observed by Keynes is the herding out effect as at the time of uncertainty people do things more by seeing others rather than taking the decisions all by themselves (Baddeley, 2005, p. 13; Nanto, 2009, pp. 140-145). Conclusion From the above discussion of the problems of the global economic crisis it can be very well inferred that this problem was the result of the existence of volatility and instability in the British housing market which can be explained by the bubbles which were accelerated by the transaction costs and the asymmetry of information which affected the supply side of the British housing market. The higher property taxes as a move from the New Labor to moderate the speculative forces and to increase the housing stock to develop the brown filed sides and to smoothen the legal process by removing the contractual rigidities are important to bring in the stability in the UK housing market. Another important aspect that has to be given concern is the restructuring of the fiscal structure of the economy, which will have an impact on the housing market. The lack of balance between the supple and the demand side of the housing market, which had led to the housing market crash, cannot be ignored. The imbalance in the sector had driven out some potential first time buyers out of the market, this has to be restricted with measures to encourage the first time buyers by changing the thresholds of stamp duty thereby making an effort to reduce the housing wealth inequality across the generations by generating long term impact on it. References: 1. Muller, A, Richard, A and M. Engelschalk, (2009), Real Estate Bubbles and the Economic Crises: The role of Credit Standards and the Impact of Tax Policy, Journal of Property Tax Assessment & Administration, Vol. 7, No. 1, available at: http://library.iaao.org/fulltext/pa1001017.pdf (accessed on May 6,2011) 2. Hay, C. 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K, (2009), The Global financial Crisis: Analysis and Policy implications, Congressional Research Service, available at: http://www.fas.org/sgp/crs/misc/RL34742.pdf (accessed on May 7,2011) Read More