UK House Prices, UK House Prices, Consumption and GDPConsumption and GDP in a Global Context in a Global Context

Andrew FarlowAndrew FarlowUniversity of OxfordUniversity of Oxford

Department of Economics, and Oriel Department of Economics, and Oriel CollegeCollege

John D Wood & Co.,John D Wood & Co., The Cavalry and Guards Club, Piccadilly,The Cavalry and Guards Club, Piccadilly,

London, 20 January 2005London, 20 January 2005This is based on a paper to be found at:This is based on a paper to be found at:

http://http://www.economics.ox.ac.ukwww.economics.ox.ac.uk/members/andrew.farlow/members/andrew.farlow(Syntax slightly improved post-presentation to make the (Syntax slightly improved post-presentation to make the

slides more easily readable given the lack of a slides more easily readable given the lack of a presenter)presenter)

Today’s Presentation: Today’s Presentation: Part Three of Five PartsPart Three of Five Parts

Part One: “UK House Prices: A Critical Part One: “UK House Prices: A Critical Assessment”Assessment”

Part Two: “Bubbles and Buyers”Part Two: “Bubbles and Buyers” Part Three: “UK House Prices, Part Three: “UK House Prices,

Consumption and GDP in a Global Consumption and GDP in a Global Context”Context”

Part Four: “Risk Premia and House Prices”Part Four: “Risk Premia and House Prices” Part Five: “Mortgage Banks and House Prices”Part Five: “Mortgage Banks and House Prices” Book: February/March 2006, Publisher: Book: February/March 2006, Publisher:

Constable RobinsonConstable Robinson

UK historically strong UK historically strong housing cycleshousing cycles

Strong housing market cycles, linked to Strong housing market cycles, linked to volatile consumption, have been an volatile consumption, have been an overriding feature of the UK economy for overriding feature of the UK economy for over three decades. over three decades.

OECD (2004): 1971-2002, UK the OECD (2004): 1971-2002, UK the strongest correlation of housing wealth strongest correlation of housing wealth and GDP of any country surveyed. and GDP of any country surveyed.

IMF(2004): The UK (along with Finland, IMF(2004): The UK (along with Finland, Ireland, and Switzerland) has had one of Ireland, and Switzerland) has had one of the most procyclical housing markets in the most procyclical housing markets in the world. the world.

Something more global Something more global this time?this time?

Something extra this time: The “first Something extra this time: The “first global house price bubble” (The global house price bubble” (The Economist)? Economist)?

Small probability large loss events matter.Small probability large loss events matter. Even if only a small chance, we should Even if only a small chance, we should

analyze the possibility. analyze the possibility. IMF, 2003 World Economic Outlook, 40% IMF, 2003 World Economic Outlook, 40%

of booms followed by busts, and 8% of booms followed by busts, and 8% cumulative GDP loss.cumulative GDP loss.

State of housing markets, part of a bigger State of housing markets, part of a bigger picture of global imbalances? picture of global imbalances?

UK House price falls and UK House price falls and GDP fallsGDP falls

No fall in real No fall in real house prices house prices (blue line) not (blue line) not followed by major followed by major fall in UK GDP fall in UK GDP (gray bands)(gray bands)

Will the pattern Will the pattern repeat?repeat?

Source: Bank of England Inflation Report, May 2004, p7, Chart 1.10.

Consumption and House Consumption and House PricesPrices

1970-mid 1990s, rapid 1970-mid 1990s, rapid increase in house prices increase in house prices (green line) (green line) accompanied by rapid accompanied by rapid growth of consumption growth of consumption (red line)(red line)

Recently, house price Recently, house price inflation has accelerated inflation has accelerated but the but the rate of growth of rate of growth of consumptionconsumption has has steadied.steadied.

Source: Bank of England Inflation Report May 2004, p12, Chart 2.1.

A breakdown?A breakdown? Misleading causation. Misleading causation. Both driven by income expectations? Both driven by income expectations?

Not directly observable. Not directly observable. Credit constraints?Credit constraints? A very different central bank A very different central bank

response next time?response next time?

More evidence: durables More evidence: durables and non-durablesand non-durables

Real durable and Real durable and semi-durables semi-durables consumption is consumption is highly pro-highly pro-cyclical.cyclical.

But need to But need to adjust for rapid adjust for rapid price falls…price falls…

Source: Bank of England Quarterly Bulletin, Spring 2004, J Power, Chart 1.

Nominal ratio of durable Nominal ratio of durable to non-durable to non-durable consumptionconsumption

Source: Bank of England Quarterly Bulletin Spring 2004, J Source: Bank of England Quarterly Bulletin Spring 2004, J Power, Chart 11Power, Chart 11..

Real house prices and Real house prices and share of durable share of durable

spending inspending in consumptionconsumption Durables more Durables more

likely purchased likely purchased on credit. on credit.

Share previously Share previously very correlated very correlated with house prices. with house prices.

Correlation has Correlation has broken down since broken down since the late 1990s.the late 1990s.

Source: Bank of England Inflation Report November 2004

More EvidenceMore Evidence Swings in spending Swings in spending

relative to income relative to income – in all periods - of – in all periods - of homeowners is homeowners is nearly as great as nearly as great as renters.renters.

But: risk premia But: risk premia and options and options thinking of owners, thinking of owners, etc.etc.

Source: BOE Inflation Report May 2004, p12, Chart 2.3, based on the Family Expenditure Survey.

PossibilitiesPossibilities Credit constraints less important?Credit constraints less important? No upwards revision in expected No upwards revision in expected

future earnings and wealth? future earnings and wealth? This would have driven higher housing This would have driven higher housing

demand (and house prices) and higher demand (and house prices) and higher desired stock of durables.desired stock of durables.

Flow increase in durables expenditure Flow increase in durables expenditure on the path to new desired stock level. on the path to new desired stock level.

Awkward ConclusionsAwkward Conclusions If If realreal income expectations are pretty stable, income expectations are pretty stable,

how could these have driven house prices so how could these have driven house prices so much highermuch higher??

Not enough ability of demographic factors and Not enough ability of demographic factors and the slow rate of house buildthe slow rate of house build to explain house to explain house price rises.price rises.

Great deal of weight placed on a credit Great deal of weight placed on a credit constraint story for house price rises.constraint story for house price rises.

But difficult to create a consistent story if But difficult to create a consistent story if credit constraints are highly important for credit constraints are highly important for housing consumption but not for non-housing housing consumption but not for non-housing consumption, especially durables.consumption, especially durables.

Or…Or… Very high real house prices (and/or low Very high real house prices (and/or low

interest rates) are not regarded as long-interest rates) are not regarded as long-term sustainable by the general public?term sustainable by the general public?

Also some distributional issues – since Also some distributional issues – since rapidly rising house prices (relatively) rapidly rising house prices (relatively) redistribute wealth from asset-poor to redistribute wealth from asset-poor to already asset-rich, from young to old. already asset-rich, from young to old. And this feeds subtle differences in And this feeds subtle differences in aggregate consumption behaviour.aggregate consumption behaviour.

Mortgage Equity Mortgage Equity WithdrawalWithdrawal 0% of household 0% of household

income in the late income in the late 1990s 1990s

Now over 8% todayNow over 8% today Yet, consumption Yet, consumption

as a percent of as a percent of household household disposable incomedisposable income has hardly changed has hardly changed (1997-today)(1997-today)

What if MEW were What if MEW were to collapse this to collapse this time?time?

Source: Bank of England Inflation Report May 2004, p 13, Chart 2.4.

Correlation between Correlation between annual house price annual house price inflation and annual inflation and annual consumption growthconsumption growth

10 year rolling correlation coefficient has collapsed10 year rolling correlation coefficient has collapsed Source: Bank of England Inflation Report November 2004, p12 Chart B.

Need to correct for…Need to correct for… Demutualisation of building societies. Demutualisation of building societies.

Windfall payments (fungible with Windfall payments (fungible with MEW) of £35 billion, or 7% of annual MEW) of £35 billion, or 7% of annual consumption, helped the jump from consumption, helped the jump from 90% to 96% in two years with hardly 90% to 96% in two years with hardly any change in MEW. any change in MEW.

Introduction of self-assessment.Introduction of self-assessment. The relationship is still weaker than in The relationship is still weaker than in

the past but nevertheless is more the past but nevertheless is more positive than it first appears.positive than it first appears.

The big consumption The big consumption story?story?

Levels v. stocks: The Levels v. stocks: The surgesurge in the in the levellevel of of consumption from 86% to 96% of household consumption from 86% to 96% of household disposable income created high rates of disposable income created high rates of growthgrowth of consumption in the 1980s. of consumption in the 1980s.

Recent consumption has run Recent consumption has run consistentlyconsistently at a at a much higher much higher levellevel for much of the last 7-8 for much of the last 7-8 years (with 3%-5% consumption growth per years (with 3%-5% consumption growth per year).year).

The big consumption story of the late 1990s The big consumption story of the late 1990s and early 2000s is the historically high level of and early 2000s is the historically high level of consumption from disposable income, low consumption from disposable income, low levels of savings, and deteriorating pension levels of savings, and deteriorating pension provision.provision.

More on MEWMore on MEW Insignificant in the Insignificant in the

UK up to 1980.UK up to 1980. 1980s liberalization. 1980s liberalization. No other country in No other country in

the EU ever the EU ever managed anywhere managed anywhere near to 8%.near to 8%.

1979-1999 Germany, 1979-1999 Germany, France, and Italy net France, and Italy net injectioninjection of 6% of of 6% of household income household income into housing. into housing.

Source: Bank of England, Office for National Statistics and HM Treasury calculations. Chart 5.5, HMT 2004 p52, not updated.

Key MEW findingsKey MEW findings 50%-60% is last-time sellers and those trading 50%-60% is last-time sellers and those trading

down, i.e. those most likely to pay off debt and down, i.e. those most likely to pay off debt and save.save.

A large proportion that is spent goes on ‘home A large proportion that is spent goes on ‘home improvement’ and ‘new goods for the home’. improvement’ and ‘new goods for the home’.

But, house prices and MEW are partly But, house prices and MEW are partly endogenous to any price bubble (family transfers, endogenous to any price bubble (family transfers, home improvement).home improvement).

Borrowers who withdraw to spend are Borrowers who withdraw to spend are concentrated at higher incomes, but a sizeable concentrated at higher incomes, but a sizeable proportion are on low incomes, and their proportion are on low incomes, and their borrowings are relatively high-level.borrowings are relatively high-level.

Low levels of serial remortgaging.Low levels of serial remortgaging.

MEW and housing MEW and housing market Transactionsmarket Transactions

UK has one of the UK has one of the highest rates of highest rates of housing market housing market transaction in the transaction in the EU.EU.

Transactions Transactions volumes matter if volumes matter if most current MEW most current MEW is released through is released through last-time sales and last-time sales and trading down.trading down.

Source: HMT Table 5.4, p51. Source: Bank of England and Office for National Statistics.

MEW cont.MEW cont. MEW is more lumpy than many credit constraint MEW is more lumpy than many credit constraint

stories suggest, which is why so much MEW is stories suggest, which is why so much MEW is immediately saved and then generates a later flow.immediately saved and then generates a later flow.

Much of the consumption flow from recent MEW is Much of the consumption flow from recent MEW is still to come. More stabilizing?still to come. More stabilizing?

If MEW plummets, there is no new flow into the stock If MEW plummets, there is no new flow into the stock of assets to generate new consumption flow. Less of assets to generate new consumption flow. Less stabilizing?stabilizing?

In ‘turning’, or stagnant, housing markets price does In ‘turning’, or stagnant, housing markets price does not fall heavily at first; transactions do. The liquidity of not fall heavily at first; transactions do. The liquidity of the market and ability to ‘release’ equity falls.Those the market and ability to ‘release’ equity falls.Those wanting to trade-down are heavily dependent on wanting to trade-down are heavily dependent on chains of buyers. Their ability to release MEW falls. chains of buyers. Their ability to release MEW falls.

But…But… Only element of MEW that seems not cyclical is Only element of MEW that seems not cyclical is

remortgaging (but evidence is hard to interpret).remortgaging (but evidence is hard to interpret). For those forms of MEW that involve For those forms of MEW that involve

borrowing…debt bites much more in a low borrowing…debt bites much more in a low inflation environment.inflation environment.

What if those borrowing on MEW are excessively What if those borrowing on MEW are excessively buying into the house ‘price rise’?buying into the house ‘price rise’?

If MEW replaces ‘more expensive’ forms of If MEW replaces ‘more expensive’ forms of debt…this dries up if house prices fall.debt…this dries up if house prices fall.

A small consumption response can still be A small consumption response can still be magnified by a big collapse in MEW.magnified by a big collapse in MEW.

If prices fall, there will be a collapse in MEW.If prices fall, there will be a collapse in MEW.

Demographics of MEWDemographics of MEW Withdrawal of equity by last-time sellers is Withdrawal of equity by last-time sellers is

much greater than injection by first-time sellers. much greater than injection by first-time sellers. Stock of debt naturally rises over time.Stock of debt naturally rises over time.

If house prices are overvalued, those at the top If house prices are overvalued, those at the top have been removing more equity than they have been removing more equity than they would have done in a less overvalued market, would have done in a less overvalued market, leaving behind on average more indebted leaving behind on average more indebted households. households.

Price bubbles are highly redistributive.Price bubbles are highly redistributive. Price bubbles are popular with voters, and Price bubbles are popular with voters, and

politicians. politicians. Element of being a ‘Ponzi’ game. Element of being a ‘Ponzi’ game.

MEW is not the main MEW is not the main storystory

Savings and pensions Savings and pensions are!are! State of the housing market, level of savings, and State of the housing market, level of savings, and

‘pensions crisis’ are linked. ‘pensions crisis’ are linked. Global liquidity story too.Global liquidity story too. If consumers believe that rapidly rising prices are If consumers believe that rapidly rising prices are

sustainable…then they may believe that current sustainable…then they may believe that current consumption can be run at very much higher levels consumption can be run at very much higher levels than in the past. than in the past.

Shocking evidence of unrealistic price expectations.Shocking evidence of unrealistic price expectations. (Case, K.E., Quigley, M., and Shiller, R.J. 2004)(Case, K.E., Quigley, M., and Shiller, R.J. 2004)

Slack taken from other parts of the household Slack taken from other parts of the household balance sheet, and over-reliance on housing to balance sheet, and over-reliance on housing to generate future pensions provision.generate future pensions provision.

What about non-MEW…What about non-MEW… If many of those withdrawing housing If many of those withdrawing housing

equity are not immediately spending, what equity are not immediately spending, what are non-MEW consumers doing to maintain are non-MEW consumers doing to maintain consumption consistently at 96% or more of consumption consistently at 96% or more of income?income? Low savings;Low savings; Eating into pensions contributions they ‘should’ Eating into pensions contributions they ‘should’

be making;be making; Non-MEW forms of debt;Non-MEW forms of debt; Relying on house prices? Some notion of ‘asset Relying on house prices? Some notion of ‘asset

value allusion’. Housing wealth fungible with value allusion’. Housing wealth fungible with other forms of savings? The cheapest form of other forms of savings? The cheapest form of credit?credit?

Saving ratioSaving ratio Shows UK Shows UK

households’ saving households’ saving ratio and house ratio and house prices (plotted prices (plotted with negative of with negative of saving ratio)saving ratio)

Paradox of thrift Paradox of thrift too in a major too in a major correction.correction.

Source: HMT 2004, Chart 6.3. p. 60. Source: Office for National Statistics and Office of the Deputy Prime Minister.

Saving ratio cont.Saving ratio cont. Correlation Correlation

between saving between saving ratio and house ratio and house price inflation price inflation one period one period earlierearlier

Source: HM Treasury, 2004, p64.

Impact of interest rates Impact of interest rates on house prices and on house prices and

consumptionconsumption EITHER house prices are less volatile than EITHER house prices are less volatile than in the past…in the past…

OR, if they are still just as volatile, the links OR, if they are still just as volatile, the links to consumption are weaker…to consumption are weaker…

OR, interest rates can cope with any OR, interest rates can cope with any problems (ease cash-flow problems, problems (ease cash-flow problems, cushion/slow house price falls, etc.)cushion/slow house price falls, etc.)

Direct and Indirect effects of interest rate Direct and Indirect effects of interest rate changes via housing market:changes via housing market: both have forces working for and against;both have forces working for and against; Both are difficult to be precise.Both are difficult to be precise.

Conclusions on direct Conclusions on direct and indirect effectand indirect effect

The direct effect of reducing interest rates after the last The direct effect of reducing interest rates after the last house price crash was large. Likely more modest today.house price crash was large. Likely more modest today.

The Bank of England should worry less this time when The Bank of England should worry less this time when raising (or holding high) interest rates, but also feel less raising (or holding high) interest rates, but also feel less confident of the power of rate cuts to make a big impact confident of the power of rate cuts to make a big impact on aggregate cash-flow.on aggregate cash-flow.

Indirect effect stronger, but not much interest rates can Indirect effect stronger, but not much interest rates can do if large speculative aspect to house prices.do if large speculative aspect to house prices.

But many caveats, including:But many caveats, including: Distribution and fragility of debt is not fully clear. Distribution and fragility of debt is not fully clear.

Caution;Caution; Credit conditions generally;Credit conditions generally; Dangers of moral hazard if perceived to be ‘bailing out’.Dangers of moral hazard if perceived to be ‘bailing out’.

Redistribution effects of Redistribution effects of falling/rising house falling/rising house

pricesprices Rapid house price rises have similar Rapid house price rises have similar

consequences to sustained budget deficits, consequences to sustained budget deficits, depressing the current real productive capital depressing the current real productive capital stock in exchange for current consumption by the stock in exchange for current consumption by the gainers.gainers.

House price booms, just like government budget House price booms, just like government budget deficits, are popular with older consumers (and deficits, are popular with older consumers (and younger bubble-motivated consumer who ‘know younger bubble-motivated consumer who ‘know no better’, or suffer asset price allusion). no better’, or suffer asset price allusion).

Like deficits, older consumers benefit from the Like deficits, older consumers benefit from the ‘borrowing’ from future generations, even as ‘borrowing’ from future generations, even as long-term income levels are reduced due to the long-term income levels are reduced due to the crowding out of real productive capital stock.crowding out of real productive capital stock.

Distributional issues Distributional issues suppressing long-run suppressing long-run

valuesvalues Depressing influences on the investment Depressing influences on the investment

potential of housing of the current potential of housing of the current generation (since the market for the value generation (since the market for the value of of theirtheir homes is the next, smaller, more homes is the next, smaller, more burdened generation) include: burdened generation) include: demographically aging population; demographically aging population; falling cohorts in younger generations; falling cohorts in younger generations; record low savings; record low savings; deteriorating provision for retirement; deteriorating provision for retirement; the burden of social security and health the burden of social security and health

increasing over time.increasing over time.

Still overvalued…Still overvalued… This and other analysis (risk premia, etc.) This and other analysis (risk premia, etc.)

suggests the market is still overvalued.suggests the market is still overvalued. Given current overvaluation, the real rate Given current overvaluation, the real rate

of return on housing for, say, the next 20 of return on housing for, say, the next 20 years is much lower than the historical years is much lower than the historical average of about 2.5% (indeed, zero is average of about 2.5% (indeed, zero is within the 95% confidence interval for the within the 95% confidence interval for the 20 year real rate of return).20 year real rate of return).

It also suggests that if correction is It also suggests that if correction is inevitable, it is not obvious that correction inevitable, it is not obvious that correction should be resisted.should be resisted.

Global House price Global House price correlations and global correlations and global

liquidityliquidity Highly synchronized positive movements in house Highly synchronized positive movements in house prices, and global build up in mortgage debt. prices, and global build up in mortgage debt.

An extremely An extremely recentrecent phenomenon that does not phenomenon that does not affect all countries equally:affect all countries equally: US, Australia, UK, China, France, Ireland, New US, Australia, UK, China, France, Ireland, New

Zealand, South Africa;Zealand, South Africa; Relatively few EU countries.Relatively few EU countries.

The correlation between real house prices and The correlation between real house prices and output (and consumption) has declined since the output (and consumption) has declined since the mid-1990s, reaching unprecedented low levels by mid-1990s, reaching unprecedented low levels by 2003.2003.

Potential for instability from outside UKPotential for instability from outside UK Hence issues of timing, interest rate decisions, etc.Hence issues of timing, interest rate decisions, etc.

Variance decomposition Variance decomposition of house pricesof house prices

Source: IMF 2004, data from: Haver Analytics; IMF, International Financial Statistics; national sources; OECD; and IMF staff calculations.

UK caseUK case

House Factor and Global Factor over House Factor and Global Factor over time, per cent change, constant prices, time, per cent change, constant prices, demeaneddemeaned

Source: IMF 2004, data from: Haver Analytics; IMF, International Financial Statistics; national sources; OECD; and IMF staff calculations.

UK decomposition of UK decomposition of house price change over house price change over

timetime Orange = ActualOrange = Actual Blue = Global Blue = Global

Housing FactorHousing Factor Red = Global Red = Global

FactorFactor Black = Country Black = Country

FactorFactor

Source: Extracted from IMF 2004

Global LiquidityGlobal Liquidity Global driving forces – especially US house prices, US Global driving forces – especially US house prices, US

interest rates, and global liquidity.interest rates, and global liquidity. 25% per year growth in the sum of America’s cash and 25% per year growth in the sum of America’s cash and

banks’ reserves held at the Fed, and in the foreign banks’ reserves held at the Fed, and in the foreign reserve holdings of central banks around the world.reserve holdings of central banks around the world.

Excess liquidity in the past flowed into traditional Excess liquidity in the past flowed into traditional measures of inflation (goods and service prices). measures of inflation (goods and service prices).

Does extreme liquidity show up in asset price inflation – Does extreme liquidity show up in asset price inflation – house prices – and record high global levels of debt, house prices – and record high global levels of debt, especially mortgage debt? Overreaction after stock especially mortgage debt? Overreaction after stock market crash?market crash?

US housing stock has risen in US housing stock has risen in paperpaper value by $5 trillion, value by $5 trillion, almost precisely matching the $5trillion of lost stock almost precisely matching the $5trillion of lost stock market wealth of the early 2000s.market wealth of the early 2000s.

Did Global interest rates Did Global interest rates go too low?go too low?

Natural rate of interest: the rate at which the supply Natural rate of interest: the rate at which the supply of savings of households exactly balances the demand of savings of households exactly balances the demand for funds by firms for investment purposes.for funds by firms for investment purposes.

Natural rate is roughly equal to the rate of inflation Natural rate is roughly equal to the rate of inflation plus the real trend rate of growth. plus the real trend rate of growth.

Natural rate moves about according to:Natural rate moves about according to: technological improvement; technological improvement; changes in preferences;changes in preferences; the impact of demographics on the need for savings, etc.the impact of demographics on the need for savings, etc.

If cost of capital set below this, get overcapitalization, If cost of capital set below this, get overcapitalization, the level of borrowing and investment will be the level of borrowing and investment will be excessive, saving too low, and the chances of bubbles excessive, saving too low, and the chances of bubbles greater. greater.

Natural rate too low, Natural rate too low, continuedcontinued

For UK about 5% (2% inflation plus 2% to 3%).For UK about 5% (2% inflation plus 2% to 3%). Global natural rate (difficult to work out Global natural rate (difficult to work out

precisely) may even have risen (China, IT, precisely) may even have risen (China, IT, global integration, inflation success, etc.).global integration, inflation success, etc.).

Yet, some of these forces have also lowered Yet, some of these forces have also lowered inflation and even encouraged lower interest inflation and even encouraged lower interest rates.rates.

And bubbles encourage households not to And bubbles encourage households not to save, making things worse.save, making things worse.

Low rates followed collapse of late 1990s and Low rates followed collapse of late 1990s and various other crises/collapsing bubbles.various other crises/collapsing bubbles.

The USThe US US (especially) interest rate kept below ‘natural US (especially) interest rate kept below ‘natural

rate’ for too long? 3% to 5% too low? Maybe rate’ for too long? 3% to 5% too low? Maybe after previous bubbles? Went from 6.5% in 2001 after previous bubbles? Went from 6.5% in 2001 to 1% in 2003.to 1% in 2003.

Past five years America’s national spending has Past five years America’s national spending has exceeded its income by about a fifth. exceeded its income by about a fifth.

Private debt has boomed (nearly $10trillion).Private debt has boomed (nearly $10trillion). Savings have hit 0.5% (compared to historical Savings have hit 0.5% (compared to historical

average of 8%). Sometime, a reversion back to average of 8%). Sometime, a reversion back to 8%?8%?

Private debt service is historically high – even Private debt service is historically high – even before interest rates rise.before interest rates rise.

US cont.US cont. US government has joined US citizens. US government has joined US citizens.

Approx $450bn budget deficit per year.Approx $450bn budget deficit per year. Externally held portion of debt risen Externally held portion of debt risen

from 20% to 45%.from 20% to 45%. Problems with ‘depth’ of US mortgage Problems with ‘depth’ of US mortgage

markets.markets. Problems with US ‘lender of last Problems with US ‘lender of last

resort’.resort’.

US cont.US cont. If a country has strongly favourable investment If a country has strongly favourable investment

opportunities – that will ultimately make its opportunities – that will ultimately make its inhabitants much better off – it is economically inhabitants much better off – it is economically rational to consume some of the fruits now, rational to consume some of the fruits now, borrow from the rest of the world, and repay borrow from the rest of the world, and repay from higher output later.from higher output later.

Meanwhile, run a strong currency and high trade Meanwhile, run a strong currency and high trade and current account deficits that generate a net and current account deficits that generate a net capital flow equal to the current account deficit. capital flow equal to the current account deficit. 

However, decomposition of US data shows that However, decomposition of US data shows that debt is currently largely being used to finance debt is currently largely being used to finance public and private public and private consumptionconsumption, rather than , rather than investmentinvestment. .

Asia and US mutually Asia and US mutually reinforcereinforce Global foreign exchange reserves have doubled since Global foreign exchange reserves have doubled since

the Asian crisis of 1998, to $3,800bn, with two-thirds of the Asian crisis of 1998, to $3,800bn, with two-thirds of this in dollars. Asia accounts for 80% of this growth and this in dollars. Asia accounts for 80% of this growth and now has 70% of global reserves. now has 70% of global reserves.

Reserves account for 9% of global gross domestic Reserves account for 9% of global gross domestic product, compared to less than 2% during the pre-1971 product, compared to less than 2% during the pre-1971 Bretton Woods era. Bretton Woods era.

High demand for US debt may be a response to previous High demand for US debt may be a response to previous crises. It has chipped 0.5% to 1% off US yields. It has crises. It has chipped 0.5% to 1% off US yields. It has helped the US to run large government and trade helped the US to run large government and trade deficits.deficits.

China has chipped 0.1% to 0.3% of US inflation (maybe China has chipped 0.1% to 0.3% of US inflation (maybe as much as 1%).as much as 1%).

In turn, China’s boom has been helped by low US rates.In turn, China’s boom has been helped by low US rates.

House price contagion?House price contagion? If sufficiently strong house price falls in one country If sufficiently strong house price falls in one country

(for example, rebalancing in the US (for example, rebalancing in the US willwill require lower require lower spending on housing consumption) or several countries spending on housing consumption) or several countries generate a decline in consumption for them, then it is generate a decline in consumption for them, then it is more likely that consumption will fall in other countries more likely that consumption will fall in other countries too:too: Real contagion (via consumption).Real contagion (via consumption). Financial contagion (via, in particular, mortgage bank Financial contagion (via, in particular, mortgage bank

and government balance sheets).and government balance sheets). Equity-based bubbles less damaging than debt-based Equity-based bubbles less damaging than debt-based

bubbles. Has mitigating the first, led to the latter?bubbles. Has mitigating the first, led to the latter? See Farlow, “UK House Prices, Consumption, and GDP See Farlow, “UK House Prices, Consumption, and GDP

in a Global Context,” Section 6, for scenarios for in a Global Context,” Section 6, for scenarios for correction.correction.

Impact on UK policyImpact on UK policy How do these possibilities affect our attitude to falling How do these possibilities affect our attitude to falling

house prices in the UK and central bank policy on house prices in the UK and central bank policy on interest rates?interest rates?

If rebalancing of the UK housing market is inevitable, If rebalancing of the UK housing market is inevitable, this suggests allowing rebalancing to proceed sooner this suggests allowing rebalancing to proceed sooner rather than later – leaving the housing market in a rather than later – leaving the housing market in a better position to withstand global disturbances better position to withstand global disturbances consequent on rebalancing elsewhere.consequent on rebalancing elsewhere.

Reversion to fundamentals, while it harms Reversion to fundamentals, while it harms consumption, at least conceivably puts the economy consumption, at least conceivably puts the economy back on a footing that emphasizes real economic back on a footing that emphasizes real economic activity over speculative housing activity and ends the activity over speculative housing activity and ends the distortions that lead to long-term pension and saving distortions that lead to long-term pension and saving misallocationmisallocation..

Lessons for the UKLessons for the UK Global instability might matter more for UK Global instability might matter more for UK

house prices than is perhaps currently house prices than is perhaps currently accepted. The fate of the UK housing market accepted. The fate of the UK housing market may currently be one of the less domestically may currently be one of the less domestically controllable aspects of UK macroeconomics. controllable aspects of UK macroeconomics.

The Bank of England has faced an unenviable The Bank of England has faced an unenviable choice between trying to turn the tide of house choice between trying to turn the tide of house prices and not sacrificing growth and risking prices and not sacrificing growth and risking under-hitting its inflation target. under-hitting its inflation target.

Emphasis on controlling the housing market Emphasis on controlling the housing market has to include reforms and not just rely on has to include reforms and not just rely on interest rates.interest rates.

Lessons for UK cont.Lessons for UK cont. Interest rates may have little power to Interest rates may have little power to

influence house prices in a price collapse influence house prices in a price collapse anyway. Trying to generate a cash-flow affect anyway. Trying to generate a cash-flow affect to offset a wealth effect caused by an to offset a wealth effect caused by an unwinding bubble may simply not work very unwinding bubble may simply not work very well.well.

Handling global surges in house prices might Handling global surges in house prices might need more of a coordinated response than it need more of a coordinated response than it probably gets, or is ever likely to get. probably gets, or is ever likely to get.

Stop-go cycle via house prices in place of stop-Stop-go cycle via house prices in place of stop-go cycle via goods and services prices?go cycle via goods and services prices?

Bubbles confuse inflation Bubbles confuse inflation signalssignals Recent asset price bubbles might have helped to dampen Recent asset price bubbles might have helped to dampen

up-front inflationary pressures. In case of equity market up-front inflationary pressures. In case of equity market bubbles:bubbles:

Artificially boost profits as measured in standard accountancy Artificially boost profits as measured in standard accountancy measures – firms adopt more aggressive pricing strategies;measures – firms adopt more aggressive pricing strategies;

Positive feedback via capital accumulation and favourable Positive feedback via capital accumulation and favourable supply-side developments, especially productivity gains, the supply-side developments, especially productivity gains, the spreading of technology, and ‘catch up’ in emerging spreading of technology, and ‘catch up’ in emerging economies (c.f. China), with consequent lower inflationary economies (c.f. China), with consequent lower inflationary pressure;pressure;

Firms able to make much lower contributions to pension Firms able to make much lower contributions to pension schemes (and employees willingly accept, c.f. US 1990s);schemes (and employees willingly accept, c.f. US 1990s);

Employees tolerate less inflationary wage claims given Employees tolerate less inflationary wage claims given perceived gains on stock market investments (especially perceived gains on stock market investments (especially evident in the US in the late 1990s);evident in the US in the late 1990s);

Bubbles confuse signals, Bubbles confuse signals, cont.cont.

Governments benefit from bubble-inflated Governments benefit from bubble-inflated asset prices that inflate the tax yield (stock asset prices that inflate the tax yield (stock market taxes at the end of the 1990s, housing market taxes at the end of the 1990s, housing transactions taxes, consumption taxes, low transactions taxes, consumption taxes, low use of pension tax allowances, etc. in current use of pension tax allowances, etc. in current housing bubble) and allow them to run lower housing bubble) and allow them to run lower tax rates than otherwise would be the case, tax rates than otherwise would be the case, even as their fiscal positions are even as their fiscal positions are strengthened;strengthened;

When the bubbles unwind, all these things go When the bubbles unwind, all these things go into reverse – just at the wrong time.into reverse – just at the wrong time.

A public sector A public sector generated cash-flow generated cash-flow

shock?shock? There are dangers in running a fiscal policy There are dangers in running a fiscal policy that risks a sudden tax increase in the face of a that risks a sudden tax increase in the face of a declining housing market (maybe at the same declining housing market (maybe at the same time as a swing in global credit conditions).time as a swing in global credit conditions).

This time, the impact may show up more than This time, the impact may show up more than usually as a public sector cash-flow problem. usually as a public sector cash-flow problem.

But burdens for the public sector are But burdens for the public sector are ultimately private sector burdens. It is simply ultimately private sector burdens. It is simply an issue of timing. an issue of timing.

If house price falls are slow enough, this cash-If house price falls are slow enough, this cash-flow problem can be offloaded to the private flow problem can be offloaded to the private sector at a more timely pace. sector at a more timely pace.

Public sector cash-flow, Public sector cash-flow, cont.cont.

If price falls are more rapid (and confidence takes If price falls are more rapid (and confidence takes a greater hit) then the cash-flow difficulty (or a greater hit) then the cash-flow difficulty (or even just expectations of it) may be fed much even just expectations of it) may be fed much more quickly to the private sector – especially in more quickly to the private sector – especially in the form of higher taxes – reinforcing the private the form of higher taxes – reinforcing the private sectors cash-flow problem and putting downward sectors cash-flow problem and putting downward pressure on house prices. The economy finds pressure on house prices. The economy finds itself on an even higher tax trajectory at quite the itself on an even higher tax trajectory at quite the least opportune time for it. least opportune time for it.

And tax rises are hard to target on the relatively And tax rises are hard to target on the relatively less indebted (unlike interest rate falls).less indebted (unlike interest rate falls).

Growing tension between Bank of England and Growing tension between Bank of England and Treasury.Treasury.

Precarious balancing act Precarious balancing act for central banksfor central banks

If rates are raised too slowly, any momentum-driven If rates are raised too slowly, any momentum-driven bubbles will expand even further, financial imbalances bubbles will expand even further, financial imbalances intensify, with inflationary pressures built up for the intensify, with inflationary pressures built up for the longer term. Adjustment is simply delayed till a point longer term. Adjustment is simply delayed till a point when the fragility is even greater and when the dangers of when the fragility is even greater and when the dangers of triggering a switch to deflation are higher. triggering a switch to deflation are higher.

If rates raised too quickly, fragilities may unwind too fast.If rates raised too quickly, fragilities may unwind too fast. Balancing act for debt holders too.Balancing act for debt holders too. This time real price falls will need nominal price falls.This time real price falls will need nominal price falls. This time the Bank of England would not allow the run-This time the Bank of England would not allow the run-

away inflation needed to create the negative real interest away inflation needed to create the negative real interest rates that would generate a similar situation today to that rates that would generate a similar situation today to that easing previous price collapses.easing previous price collapses.

Central bank difficulties, Central bank difficulties, cont.cont. Interest rates may have too much to do Interest rates may have too much to do and be unable and be unable

to fall as far as the housing market might requireto fall as far as the housing market might require:: If the pound were to weaken too quickly;If the pound were to weaken too quickly; OR oil or commodities prices rise too strongly, feeding OR oil or commodities prices rise too strongly, feeding

UK inflationary pressures;UK inflationary pressures; OR the US were to suffer a fiscal crisis and sudden swing OR the US were to suffer a fiscal crisis and sudden swing

in sentimentin sentiment forcing forcing itit to raise real interest rates much to raise real interest rates much higher in defense;higher in defense;

OR UK government finances were to deteriorate quickly OR UK government finances were to deteriorate quickly as lower confidence and economic activity reduced the as lower confidence and economic activity reduced the tax yieldtax yield..

Rising spreads may keep interest rates off the floor.Rising spreads may keep interest rates off the floor. System has not been stress-tested yet. Best to set so as System has not been stress-tested yet. Best to set so as

to minimize the fall-out from mistakes.to minimize the fall-out from mistakes.

Central banks cont.Central banks cont. Policy in the late 1990s settled on price stability via Policy in the late 1990s settled on price stability via

interest rate adjustments and not tax adjustment, since interest rate adjustments and not tax adjustment, since easier to set up an institution independent of elected easier to set up an institution independent of elected government.government.

Danger that governments rely on – even over-exploit – Danger that governments rely on – even over-exploit – the policy credibility created by central banks. the policy credibility created by central banks.

A slow revision upwards of interest rate expectations is A slow revision upwards of interest rate expectations is better than a sudden unexpected tax rise. Gradual better than a sudden unexpected tax rise. Gradual reversions without surprises are best.reversions without surprises are best.

Openness about interest rates – and at least the chance Openness about interest rates – and at least the chance for households to think the scenarios through and for households to think the scenarios through and factor higher interest rates in – contrasts sharply with factor higher interest rates in – contrasts sharply with the complete lack of openness about (and the political the complete lack of openness about (and the political nature of) the timing and level of future tax rises. nature of) the timing and level of future tax rises.

A Few Summary A Few Summary ThoughtsThoughts

Global rebalancing at some point.Global rebalancing at some point. Expected consumption and GDP response will Expected consumption and GDP response will

matter. matter. Much of the analysis of the consumption Much of the analysis of the consumption

response is based on efficiently operating response is based on efficiently operating bubble-free markets. bubble-free markets.

Once we allow bubble mispricing, consumption Once we allow bubble mispricing, consumption responses are generally not well captured.responses are generally not well captured.

Soft landing is not fully convincing when a broad Soft landing is not fully convincing when a broad picture of consumption is considered, including picture of consumption is considered, including pension and savings, and when levels as well as pension and savings, and when levels as well as changes in levels are reviewed.changes in levels are reviewed.

Continued on next slide…Continued on next slide…

A few summary thoughts A few summary thoughts cont.cont.

Debt-backed housing bubbles probably more Debt-backed housing bubbles probably more damaging than stock market bubbles.damaging than stock market bubbles.

The new stop-go cycle?The new stop-go cycle? Politicians love to exploit bubbles.Politicians love to exploit bubbles. Aftermath of current period likely to focus attention Aftermath of current period likely to focus attention

on a wide range of issues. on a wide range of issues. Many of these require Many of these require coordination across diverse economies, something coordination across diverse economies, something usually achieved more easily in stable times. In less usually achieved more easily in stable times. In less stable times, something much easier to handle if stable times, something much easier to handle if some thought has gone in ahead of time. some thought has gone in ahead of time.

Being better educated helps. Caricature of Being better educated helps. Caricature of ‘optimists’ or ‘doomsters’, ‘experts’ or ‘pundits’ ‘optimists’ or ‘doomsters’, ‘experts’ or ‘pundits’ does not help.does not help.

THIS IS THE LAST THIS IS THE LAST SLIDESLIDE