Sunday, 22 May 2016

Osborne Understates The Effect of Brexit on Property Prices

On Friday, in Japan, George Osborne, on the basis of a report to be published, next week, by the OBR, said UK house prices could be up to 18% lower by 2018, if the UK votes to leave the EU. As some commentators have said last week, that could be a good reason for people to vote to leave, rather remain! If you live in the South of England, where house prices have become particularly astronomical, and the prospect of buying has become ever more remote, the idea that property prices might drop, so that you could have a chance of buying, for the first time, or moving up to a better house, might be tempting.

Of course, the Brexiteers have denied Osborne and the OBR's claims, because they are the purest representatives of those traditional conservative forces of the landed and financial aristocracy. Moreover, they are relying on the votes of all those older people, who read the Daily Mail and Express, and who for years have been hoodwinked into the idea that rising house prices have made them better off, rather than, as with any rising prices, made them significantly worse off! The Brexiteers may even have miscalculated there though, because the latest polls show that a majority of people now see high and rising house prices as a bad thing, as it gradually sinks into people that their kids can't afford a house, and that they can't themselves afford to move up to a better house. Who would have thought that when things that workers have to buy get a lot more expensive, that workers get much poorer rather than richer as a result?!

The Brexiteers have brought out a range of people to claim that even if the Pound falls, and mortgage rates rise, house prices will continue to go up, because the demand for houses continues to rise. But, that is just bad economics from some economists who should know the difference between need and demand. There is a big difference between the need for housing continuing to rise, because population grows, and the structure of families change, and that translating into a demand for houses. I might feel that I have a need for a Lamborghini, but unless I have the money and willingness to use it to buy one, that need does not become a demand. The same with houses, there may be many people who need a house, but unless they have the money to put down a deposit, to be able to pay the monthly mortgage interest and so on, that need does not constitute a demand. 

Just look at all the homeless people. They undoubtedly need a home, and the more homelessness rises, the more that need for a home rises. But, it does not constitute a demand, precisely because all those homeless people, and millions more in only a marginally better position, do not have the wealth or income to be able to turn that need into a demand. Market prices respond to the interaction of supply and demand not supply and social need! Its only if people have the money to be able to actually demand houses that it can have an effect of pushing up house prices. Currently, an increasing number of people lack the money to be able to provide such demand, and that is illustrated by the continued fall in home ownership, reversing a trend that had existed for decades.

The figures for the numbers of houses being bought are themselves deceptive, but an increasing proportion of the houses that have been bought, particularly of cheaper houses, have been by “Buy To Let” landlords. In fact, that has been one factor keeping the property bubble inflated, and making it harder for people to get on to the housing ladder, as the NEF showed recently. The Buy To Letters have have tax advantages over other house buyers, because they can set off half their mortgage interest payments against income for tax purposes. It used to be all of the interest until the last Budget. They push up the prices of entry level properties, which makes it more difficult for real first time buyers to buy them.

But, as I showed some time ago, the demand side of the equation is deceptive, and open to a quick reversal. For example, if there is a Brexit, there may not only be fewer migrants coming to the country, but many of those here may leave. That would mean lots of current rentals will disappear, and those migrants who had been able to buy a house, will then be sellers. But, the supply side is deceptive too. Not only would any such moves throw a large amount of existing rental property on to the market, but the fact is that the amount of available housing per person is already 50% higher than it was in the 1970's.

In fact, Osborne's statement, rather than exaggerating the potential effect on house prices understates it. The effect has been based upon the likely effect of a rise in interest rates affecting mortgage rates, and the deterrent effect that will have on potential buyers. That is undoubtedly one effect, as will be the huge numbers of existing home-owners who do not realise just how much a small percentage point movement in mortgage rates will add to their monthly repayments. For example, if you have a £100,000 mortgage and your current mortgage rate is 4%, the interest is £4,000 a year, or £333 per month. If the mortgage rate rises to just 6%, your monthly interest payment will rise by 50% to £500 per month.

For many people, already borderline in being able to meet their monthly outgoings, that kind of rise in monthly payments will be impossible. But, mortgage rates could rise much more than that from their historically low levels, and that is even without Brexit. Global interest rates are rising, and they will rise here too. Brexit will just mean that they rise faster.

However, the real reason that higher interest rates cause property prices to drop is not this effect on affordability of mortgages. The real reason is because of the process of capitalisation, which is the means by which revenue producing assets such as land are priced. If interest rates double then basically the prices of such assets halve. If the price of an acre of land is currently £100,000, if interest rates double from say 1.4% (the yield on the UK 10 Year Gilt) to 2.8%, then the price of the land falls to £50,000.

As the NEF video shows, 90% of the rise in the price of new homes is accounted for by higher land prices. There is a chicken and egg situation here. Speculation over existing houses, fuelled by lax credit has pushed up the prices of those houses. In the process, the higher prices of these existing houses, pushes up land prices, and higher land prices, pushes up the cost of building new houses. Higher prices of new houses, also means that demand for those houses is choked off, because potential buyers cannot afford them – pace the point made at the start about the difference between need and demand – so builders will only build a small number of new houses that they know they can sell. That means the supply of houses grows only slowly, which is why the number of new houses being built is at historically low levels, despite astronomically high house prices.

That, in fact, is the most obvious refutation of the claim that high house prices reflects a high level of demand relative to supply. If that were the case, then housebuilders would be making huge profits from building new houses, and would be falling over themselves to build as many as they could. They are not, and the reason they are not is because there actually is not significant demand for houses at their current ludicrously high prices. That means that if builders built more they would have to sell them at lower prices, which would mean they would make no profit on them.

So, builders prefer to sit on their own huge land banks, and landowners sit on huge tracts of land that could be used for building. That keeps land prices high, which keeps the cost of building new houses high, which means that house prices in general stay high. Unless the state were to nationalise or compulsory purchase large tracts of land, at low prices, so as to make it available for building, the only way to resolve this problem is for interest rates to rise, so that existing house prices are crushed, and so that then land prices also fall.

Global interest rates are rising, and such a process of crashing asset prices is inevitable, but if it continues to look like Brexit is possible that process will be brought forward and intensified. A Sterling crisis is inevitable if Brexit looks likely, and that will push up inflation and interest rates. The Bank of England will be powerless in such circumstances. Firstly, with a collapsing Pound it will have to intervene to shore it up with higher official interest rates, not reduce them. Secondly, it may be able to step in to buy up even more UK Gilts, but only at the cost of pushing up inflation even higher, and encouraging foreign holders of those gilts, and other sterling denominated bonds to sell them, as they fear the value of those assets depreciating, due to inflation.

Moreover, as I pointed out some time ago, the Brexiteers have the wrong end of the stick when it comes to trade. The EU will indeed want to continue to sell to UK consumers, and those consumers will want to continue to buy EU commodities. The problem is that the UK will find it increasingly difficult to cover the cost of those imports by its own exports. That will be not because of formal EU tariffs on UK goods, but because UK producers will find that their costs rise relative to EU producers. Moreover, EU based companies like BMW will site their production in EU countries rather than Britain. Where currently BMW Minis go out from Cowley to the EU, they would instead be produced in Germany and be imported to the UK.

The UK already has a huge trade deficit, because of decades of neglect from the Thatcher years onwards, that has left UK industry under invested and under capitalised, with falling levels of productivity, increasingly unable to compete on the world market. That will intensify, and so the UK will find itself increasingly paying for its imports by shipping capital rather than commodities abroad. As capital, thereby drains out of the economy, the value of the currency is forced down, and increasing austerity is required within the domestic economy.

Far from overstating the effects of Brexit, Osborne and the OBR are understating it.

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