All sorts of reasons are indicated by the media to explain the exponential rise in house prices which we have witnessed in the past 20 years and which is increasingly causing a serious housing crisis, especially in London.
According to common wisdom, as shaped by the media, the main reasons have to be found in: the dramatic rise in foreign investment, the constant increase in population due mainly to immigration, and the insufficient supply of newly built housing, unable to keep pace with a swelling demand (due to population growth and foreign investors). The media make no mention of either the changes in social housing policies implemented by the Thatcher government and never reversed by successive governments, or the spectacular increase in mortgage money, created by the banking sector in the past 20 years. On the other hand, this last explanation features very prominently in the Positive Money narrative, both in the website and in the book (Modernising Money), and it is best illustrated by the graph below.
Between 1997 and 2007 the number of housing units grew by 8%, while the population only grew by 5%. Meanwhile mortgage lending grew by 370% over its 1997 level. The result? 206% increase in house prices!
Without taking anything away form the power of the PM graph to give a concise and easy to grasp representation of reality, I will dig a bit deeper to uncover the story behind all this money creation. The starting point of my analysis, which is based on a work done by the New Economics Foundation, will be the factors affecting demand and supply, but this is only the starting point, as much more is involved and, as the analysis proceeds, it will become clear that our houses are at the centre of a much bigger game, in which government policies play a crucial role, and which ultimately affects nothing less than the functioning of the whole economy.
The starting points to understand the continuous escalation of house prices, are two major factors affecting the demand and supply of housing, both factors due to policy changes set in motion in the 80’s by the Thatcher government:
- On the supply side, the privatisation of social housing
- On the demand side, financial deregulation which poured vast amounts of purchasing power into the housing market, by making possible easy mortgages.
These policy changes interplay in a perverse manner with a more permanent factor: the basic fact of life that houses are built on land and land is limited. In a sense, land is like gold. The reason why gold has always played an important role in past monetary systems, is the fact that its supply is limited and cannot be expanded rapidly (it can only increase approximately by less than 2% a year). Now that money has been de-linked from gold (after the collapse of the Bretton Woods system in 1971) housing has increasingly been propelled into very important (and very improper) roles both in our monetary system and in the wider economic system.
Understanding the dynamics of house prices means understanding the ever expanding roles that houses have been taking on over time. The privatisation of public housing and the reform of the banking sector, coupled with the inescapable limit posed by the availability of suitable land, have conjured up to transform the main function of houses from dwellings into assets, at the centre of incessant speculation. The first part of this paper will outline all the factors affecting the demand and supply of housing that have led to this transformation. Once transformed into assets, the roles of houses have escalated over time: they have gradually become the main collateral sustaining our monetary system, they then have been transformed into a major instrument of monetary policy, and eventually they have come to function as a magnet for much needed foreign capital. The second part of this paper will outline the main steps which have led to this escalation in the importance of our housing stock, while highlighting the context in which this escalation has been unfolding: the neoliberal economic paradigm which replaced the previous paradigm based on the Bretton Woods system. Ultimately, understanding the dynamics of house prices means understanding how the neoliberal economic paradigm works, its un-sustainability, and the crucial role that house prices play in propping it up. Rising house prices play a primary role in sustaining the shaky credibility of our monetary system, trends in house prices affect the whole economic cycle and are crucial for our ability to attract much needed foreign capital. For all of these reasons, our authorities have no choice but to favour relentless price rises, if they want to avoid a major economic slump and a financial collapse. It will then become clear that the problem of unaffordable housing cannot be resolved without questioning the whole neoliberal economic paradigm that we happen to live under.
PART 1 – DEMAND, SUPPLY AND TRANFORMATION OF HOUSES INTO ASSETS
We can now look at the individual factors affecting the demand and supply of housing in the UK. On the supply side, the main factors to be considered are public supply and private supply. On the demand side, we will look at the factors affecting strength of preference, purchasing power and the number of buyers.
SUPPLY SIDE – privatisation of the public housing supply
To analyse the factors affecting the supply of housing, it is useful to start with the graph overleaf which shows the amount of house building by sector that took place in the years between 1946 and 2013.
We can see from the graph that private sector building increased rapidly from 1946 to 1968, and since then it has remained stable up to the present time. Public sector building likewise increased sharply up to 1968 and for all those years (1946-1968) it was as high (and even higher in some cases) as private sector building, then decreased sharply and practically stopped by the early 90’s. Therefore this is one of the big changes that has taken place in the last 25 years: no more social housing being built.
This graph presents a clear picture of how the UK housing supply has evolved since the end of the Second World War: total house building has declined sharply since 1968, due primarily to a sharp decline in social housing being built (this is a policy choice), and the shortfall has not been compensated by the private sector. The private sector has not compensated the shortfall because it is not very responsive to rises in demand, and we will see later why.
The other dramatic change in policy affecting the supply of public housing was the introduction of the right to buy legislation: at the same time that the building of social housing slowed down dramatically, the Thatcher government removed houses from the public sector by putting them ‘for sale’ into the private sector. This is what happened:
No more building of social housing + right to buy legislation = privatised (and increasingly insufficient) housing supply –> rising demand for home ownership
At the same time that the central government relinquished its involvement in the housing supply, local authorities were forbidden to step in by having imposed on them a borrowing cap that prevents them from borrowing money against the value of their existing housing stock. This borrowed money could have been used to build or buy more houses, something which private landlords do all the time! After many years, the results of these policies are:
1) Instead of having a stock of publicly owned housing that brings in rental income for the public purse, the government now pays over £9 billion per year in housing benefits to private landlords!
2) The social housing waiting list stood at around 1.7 million households in 2013, a 65% increase since 1997 (and this figure is under estimated, as the government, to shorten the list, keeps on restricting eligibility). Thus more and more people who would have once rented from a council or a housing association are forced instead into the private housing sector, either as aspiring homeowners or as tenants, increasing the demand for mortgages, both for primary homes and for buy to let (BTL) properties.
Privatisation of housing supply + payment of housing benefits to private landlords = public subsidy for the buy to let (BTL) market –> rising demand for BTL homes
To sum up the situation on the public supply side: starting from the 1980’s we have these two dramatic policy changes: withdrawal of government intervention from house building and introduction of the right to buy legislation. This has led over time to a chronic shortage of social housing, increasing the numbers of people unable to get social accommodation and swelling demand for home ownership (in order to escape private renting) and for private renting, for those unable to access the housing ladder. Both these trends have led to increased demand for mortgages:
- Demand for home ownership —> rise in demand for mortgages
- Demand for private renting + public subsidies to the BTL market —> opportunities for BTL landlords —> rise in demand for BTL mortgages
Therefore we can see that important policy changes reducing the supply of public housing have led to an increased demand to buy houses in the private market, and hence for mortgages. There are other factors affecting the demand for houses, as the authorities have wilfully incentivised the demand both for home ownership and for BTL homes.
DEMAND SIDE – incentives boosting strength of preference for home ownership and BTL:
At the same time that the supply of social housing was being reduced by putting up for sale the existing stock and not replacing it with new built, a rhetoric was also being spread by the media and policy makers, pushing preferences for home ownership. In the words of Michael Haseltine: ‘home ownership stimulates the attitudes of independence and self reliance that are the bedrock of a free society’. Along with ideology there were also specific measures taken in the direction of home ownership favouritism:
- Tax breaks (‘schedule A’ scrapped, MIRA’s 1969-2000, exemption from capital gain tax)
- Various subsidies for home ownership (the Right to Buy scheme involved selling public housing at bargain prices, more recently the Help to Buy scheme subsidises deposit requirements for mortgages)
- The neglect of council house maintenance
- The dismantling of rent controls and tenants rights, paving the way for higher rents and a thriving BTL sector (housing acts of 1980 and 1988)
- As mentioned before, subsidising the BTL sector with housing benefits (money that could have easily been kept within the public purse).
As a result of the above measures, combined with cheap mortgages becoming increasingly available, being a homeowner has become increasingly more convenient over time compared to renting. The portion of income spent on housing is now around 15% (on average) for homeowners with a mortgage, compared with 25% for social housing tenants and 35 % for privately rented housing. Between 1969 and 1989 these percentages were similar, they started to diverge sharply from 1989 on. Therefore it is no wonder that the preference for home ownership has increased so much!
In addition to specific measures, a more important role has been played by structural changes in the way the economy is managed (all part of the neoliberal economic paradigm), which greatly increased the need/attractiveness to own homes and second homes as assets:
- The dwindling of public pensions and of the welfare system has acted as an indirect, but powerful incentive to become homeowners (as homes offer long term financial security) and if possible, to buy second homes and enter the profitable BTL market.
- Another indirect incentive comes from the deregulation of the financial markets, which over time has resulted in the high unreliability of financial assets (both in terms of value and returns) and left housing as one of the very few safe assets remaining as possible stores of wealth.
- Last but not least, dwindling wages and rising unemployment due to de-localisation and technological change, have created the necessity to integrate work related income with income generated by assets (rents and capital gains).
Thus at the same time when our policy makers were reducing the supply of public housing, and spreading a rhetoric to encourage people into home ownership, they were also giving solid incentives both for home ownership and for BTL landlords.
All of these factors contributed to dramatically increase the demand for home ownership and consequently for mortgages. The next step is to look at how private supply has interacted with the increased demand.
SUPPLY SIDE – unresponsive private supply
Unlike what economic theory would predict, we have seen no increase in private supply to respond to the massive increase in demand for housing. Over time, prices have run away, but supply has not responded accordingly, and this is due to the limits imposed by land availability. This is how the private house building market works.
Housing supply is determined by interconnected markets in land, second hand homes and construction. Of these, the land market is the most important. As pointed out before, the supply of land cannot be easily increased. In addition, the oligopolistic and non transparent land ownership in this country (the land registry for England and Wales is at least 35% incomplete) makes land scarcity even worse.
As a result of a scarce (and oligopolistic) supply of land, the high level of demand in the housing market has had a huge impact on land prices. In fact, three quarters of the rise in house prices in this country since the 1950s can be explained by rising land prices. This means that developers must compete to pay the most they can in order to acquire the land they require. Therefore, the developer that is able to squeeze more than everybody else its build quality, the proportion of new build allocated to affordable housing, and its infrastructure costs, will be able to offer the highest price to the landowner and win the site. This extreme bidding for land tends to put the developers at the margins of viability and, once the site is won, will set in motion the following forces, all limiting the actual building of houses:
1 Over reliance on land banking: it is much easier for developers to focus on making money from buying land, and then adding value to it through the planning process, rather than the actual business of building houses. To get an idea of the scale of the profits: land without planning costs 9000 per acre, land with planning costs 500,000 per acre in Birmingham and 1.7 million in London.
2 Drip feeding housing supply is part of the business model: this is due to the fact that a growing percentage of the costs of residential development is taken up by land prices, therefore the development tends to be at the margins of viability. As house prices have become more volatile, developers must avoid at all costs a fall in house prices during the time necessary to build. This leads to a structural incentive to constrain supply, as too many homes on sale might lower the sale price and erode profits to the point where the developer cannot pay off the land cost incurred. For this reason, as soon as house prices start to show signs of going down, developers stop building until prices rise high enough to restore profit margins. And they have no difficulty doing this, because they hold a monopolistic position. Once they’ve bought the land, no one can steal their market. (Their monopolistic position also explains the poor building standards).
In addition, lack of competition and diversity in the building sector is also a factor that operates to restrict supply. It is the result of many decades of consolidation. The scale of land banks held by larger companies and the lack of transparency around land holdings makes impossible for smaller builders to enter the market and limits self-build output.
Lastly, it must be noted that there is no taxation to redress these structural failures of the private housing market.
The above factors explain why the private sector is structurally incapable of providing the quantity and quality of housing necessary and they also explain why this country, along with many others, used to have a policy of strong government intervention in the housing market for many decades.
So far we have seen how important policy changes affecting public housing, combined with structural limitations in the supply of private housing, are setting the stage for the transformation of houses into assets. To sum up:
Privatisation of public housing +public subsidies for BTL landlords + various other incentives, including dismantling of the welfare state = rising demand for privately built houses (and consequent demand for mortgages) + limited supply = high pressure on prices = houses ready for transformation into assets
We now have all the necessary ingredients to transform houses into assets, high demand, limited supply and consequent pressure on prices. It is by providing the necessary purchasing power that the transformation into assets gets completed.
DEMAND SIDE – the explosion of mortgages transforms houses into assets
The desire/necessity for home ownership can only turn into effective demand when the potential buyers can find the money to back it up. If the money for house purchases were limited to the combined pool of savings that households had at their disposal, the bidding war could only push prices up to the limit of the available money. But this is not the case, because huge amounts of credit in the form of mortgages have been made available to the UK housing market.
Starting from the mid 90’s, we have witnessed a relentless escalation of domestic mortgage lending. In the 10 years leading up to 2008 bank lending doubled the money supply in the UK: of this new money 40% went into mortgages. The total value of mortgages rose from 20% to 40% of GDP. Since then it has continued to grow and it is now worth approximately 60% of GDP. This huge increase in mortgages was made possible by a comprehensive reform of the banking system and was later enhanced more and more by financial deregulation.
As all Positive Money followers know very well, the credit that banks lend for mortgages does not come from money in someone else’s savings account, but it is, for the most part, new money created specifically to fund the loan, this constitutes an increase in the money supply. This ever increasing amount of money relentlessly poured over a very inelastic supply of housing, has led to the familiar phenomenon of house price inflation, leading in turn to expectations of ever rising house prices, and transforming houses in to assets. To sum up:
Privatisation of public housing +public subsidies for BTL landlords + various other incentives = rising demand for privately built houses (and consequent demand for mortgages) + limited supply = high pressure on prices + explosion of mortgages = ever rising house prices —> expectations of future price rises —> transformation of houses into assets
Thus we have reached the stage when this second function of houses, as assets, which to some extent had always been present, becomes first and foremost. This is a clearly dysfunctional outcome, responsible for setting off a vicious cycle of further increases in the demand for housing (promptly matched by a plentiful provision of more money) by increasing the number of aspiring buyers. The new buyers include people who want to a) own larger homes and second homes and b) foreign buyers. Eventually the financing for these purchases will spread further afield to people who invest in titles representing real estate in the financial markets.
Further rise in DEMAND – rise in the number of buyers
The number of buyers is obviously affected by an increase in population, but this hasn’t been particularly dramatic (as previously noted, only 5% in the 10 years between 1997 and 2007). The two factors that have affected demand for housing more substantially are the increase in the number of dwellings per household (or number of second homes), and the entrance in the market of non resident (or foreign) buyers.
The rise in income inequality, due mainly to the financialisation of the economy (a crucial aspect of the neoliberal economic paradigm), has led not only to the bidding up of house prices in London and the South East, but also to a more overlooked effect: an inefficient use of our housing stock due to increased demand for larger homes and second homes. Inequality in housing in the UK (measured by rooms per person) is at its highest level for a century. The demand for second homes can be divided into two categories, for consumption (conspicuous consumption) and, the more important one, as assets. Normally these two aspects are intertwined, but can be separated for analysis purposes.
Second homes for conspicuous consumption – a few statistics
Between 2001 and 2011 the number of properties in England and Wales recorded as having no usual resident (including both vacant and second homes) increased by 185,000 (a 21% increase). For comparison, just 203,000 new homes were built by housing associations and councils over the same period. For every 8 houses built in that period 1 fell empty. It appears that most of this increase was due to the rise of second home ownership: there was a 55% increase in the number of English households with at least one second home in England between 1996/97 and 2012/13.
Second homes as assets
The more important reason leading to an increased number of buyers is the increased demand for houses as assets. As already mentioned, the demand for second homes as assets is based on: a) the necessity for a secure store of wealth, b) expectations of rental income and capital gains. This demand comes from:
1) Ordinary British households
2) British wealthy people, businesses and speculators of various kinds
3) Foreign investors and tax dodgers – Britain’s housing market is the fourth most attractive destination in the world for foreign investors looking to put their money into residential property assets. Seven out of ten London houses sold for more than 5 millions go to foreigners.
This demand for housing as assets has taken the form of:
1) Investments in the buy to let market both by big investors and by ordinary households. It is interesting to note that the demand for this type of investment has actually increased quite sharply since the financial collapse of 2008: there has been a 40% increase in buy to let mortgages since 2008. Landlords own 1/5 of the nation’s housing stock.
As noted before, BTL landlords have benefited from:
- scrapping of rent controls
- introduction of 6 month short hold contracts in the 1980’s
- rules around borrowing allowing BTL landlords to access mortgage finance more easily than first time buyers
- various tax breaks, only reduced recently
- a secure source of income from housing benefits paid to their tenants
2) Investments in prime property (buy to leave) by foreign and domestic elites
A few statistics: Savills reported that 7 billion overseas money was spent on high end London homes in 2013, accounting for 80% of prime property purchases. They found that 2/3 of these purchases were for investment purposes (Allen 2015). According to the Financial Times (2015), over 100 billion of London property was purchased by foreign buyers in the six years following the crash.
3) speculative and tax dodging investments £122 billion of property in England and Wales was purchased by companies in offshore tax havens where property is difficult to trace between 1999 and 2014. Who are these speculative investors? Many are taking on debts that are many times their income for fear of missing out on capital gains…..
PART 2 – THE ESCALATION OF ROLES PLAYED BY OUR HOUSING STOCK
We have now seen how houses, thanks to a combination of policy changes, limited land availability and vast amounts of purchasing power provided by the banking sector, have switched their primary function from dwellings into assets. This completes the first part of the story, relating to demand and supply. As anticipated, at some point the role that houses play in our economic system started to escalate. In order to understand how this happened we need to look at the wider context.
The neoliberal economic paradigm
Allowing banks to vastly increase the money supply by granting a high volume of credit, of which mortgages took a large share, was part of a major policy shift, and directly instrumental to it: changing the basis of our economy from production to finance. All the policy changes outlined so far must be considered in their interrelatedness. It is only by looking at them as parts of a larger mechanism, the neoliberal economic paradigm, that we can understand their logic and their purpose. The shift, marked by the dismissal of industry and the rise of the City of London as the main engine of the British economy, was operated during the late 70s and early 80s. It was accomplished through a series of policy changes: the gradual dismantling of the welfare state, the privatization of public industries and public housing, and a major overhaul of the banking and financial sector, which is known with the name of de-regulation, but is more complex than that, because it involves a profound change in the monetary system (increased privatization of the money supply as bank debt, along with its explosive growth) and it is accompanied by a very accommodating monetary policy, with the Central bank sustaining the debt based speculative economy all the way.
The key element of this model, is the fact that it is based on consumption not accompanied by an adequate level of production. This is the consequence of having outsourced production to countries where labour is very cheap and, in turn, brings about important consequences:
1) A high level of structural unemployment in the UK, which puts a cap on wages while boosting profits.
2) As a result of stagnating salaries, households have no alternative but to get into debt if they want to maintain their standards of living.
3) This high level of debt is also necessary to maintain an adequate level of economic activity, enough to avoid recessions and depressions.
4) Over time debt accumulates and becomes unsustainable.
5) At the same time, as this is an economy supported by foreign production, the country accumulates trade deficits and its foreign debt starts to pile up.
All of the above means that, over time, ordinary households incur in larger and larger debts to sustain their standards of living. Over time increasing portions of this debt come to be held by foreign creditors (who tend to be from the same countries that produce the goods we consume). A very important fact is that the collateral of this rising debt is mainly constituted by our housing stock. To understand how this works, we need to start with the reform of the credit market.
Reform of the credit market
The explosion of mortgages that has taken place in the past 20 odd years, was made possible by a far reaching reform of the credit market that took place in the 1970s and 80s. The reform produced a major shift for the banking sector towards reducing business loans and increasing mortgage lending, and this was perfectly reasonable in the new economic environment, as industries were being dismissed and the productive economy downsized. The reform consisted in extending to banks the right to grant mortgages, a right that previously only building societies (a very different institution, controlled by its members) were allowed to have, an arrangement which greatly constrained the total amount of money available for mortgages. In the newly deregulated environment, our banking sector has been transformed considerably. Banks have merged and grown bigger (now we have only 5 major banks) and we have lost small banks that used to have relationships with businesses. Lending for production has gradually been replaced by lending for consumption, in the form of mortgages and consumer credit, resulting in considerable advantages for the banks in terms of profit margins as this new model requires less work and carries seemingly less risk (at least in the short run, because in the long run there is a build up of systemic risk). Banks have been able to develop a more hands-off, centralised approach to their lending activity, using automated credit-scoring techniques to make loan decisions, in turn made possible by the fact that the loans are seemingly safe, as they are backed up by the value of the properties used as collateral. The advantage of this new model for the banks is clear: if a bank lends against a property and the borrower defaults, the bank can sell off the property to recover the value of the loan. On the other hand, lending to businesses, besides requiring a lot more involvement (and thus higher costs) to assess and monitor the business project, is also considerably riskier, as the bank has little or no collateral to sell off in case of default.
Consequence: housing as collateral for a pyramid of debt
However safe it might have appeared for the individual banks, this shift towards lending for mortgages over time has brought about very serious consequences for our banks and the entire monetary system:
- As the money supply in our economy has been increasing exponentially, and most of the new money has been created as mortgages (and other debt), the nature and size of the money supply has changed, from a reasonable amount of mainly positive money, to an ever increasing pyramid of debt
- The balance sheets of our banks are now very distorted, their capital is based on the value of land and of the houses built on top of it, hence very vulnerable to the price decreases that might occur during economic downturns.
All of this means that our housing stock, after having been privatised and turned into an asset, has been gradually charged with an additional responsibility: to function as collateral backing up, as some sort of a gold reserve, an ever expanding supply of debt-money. In normal circumstances the money supply of a country should consist mainly of positive money backed by production, instead we now have a pyramid of debt whose credibility rests to a considerable extent on the value of our housing stock.
Financial deregulation and the exponential expansion of the debt pyramid
We must now introduce another element: money from abroad propping up the stability of this debt pyramid. As it is widely known, the reform of the banking system went hand in hand with a progressive deregulation of the financial sector. Financial deregulation consisted of:
- Opening up the country to a massive influx of foreign capital to buy financial assets and real estate.
- Being able to create more money in the form of mortgages backed up by the money coming in.
Thus foreign investors eager to buy pound denominated assets ultimately sustain an economic model based on outsourcing production and financing the relative trade deficits by importing capital into the City. The money harnessed by the financial markets is pumped into a vast array of UK assets, among which housing occupies a prominent role. We could say that, as our economy is sustained by foreign production (our own production being insufficient), our money is ultimately backed by foreign willingness to buy pound denominated assets. (And this willingness will continue for as long as we are willing and able to pay the price). Under the new deregulated regime, the inflation of the debt pyramid unfolded in two phases:
1st phase – as the housing market was privatised and banking de-regulated, more and more money started to be created as mortgages inflating house prices. Then, attracted by the rising prices, more money entered the country for investment and speculation purposes, allowing even more money to be created as mortgages, further inflating prices and gradually building up a pyramid of debt. This pyramid could only be sustained for as long as average incomes managed to keep up with increasing mortgage repayments. At some point (possibly around the time of the bursting of the dot-com bubble in 2001, when it became clear that the new economic model was unable to kick start a process of sustained economic growth) the viability of the debt pyramid started to become more and more doubtful, as people’s debts maxed out, in the face of stagnating salaries.
2nd phase – This is when the financial markets, which in the meantime had been deregulated more and more, started to play a major role in propping up a clearly unsustainable trend, by stepping up dodgy practices that, under the name of ‘financial innovation’ in reality amount to legalised fraud. The trick the financial sector resorted to keep on building up the pyramid of debt was securitisation, that is, slicing up mortgages, mixing various slices with different degrees of risk, repackaging them as apparently safe securities (with the complicity of the rating agencies) and selling them off in the wider financial markets. This means that the banks granting the mortgages were able to transfer the risk involved in their lending activity to the people (pension funds, local governments, investors of various kinds scattered all over the world) who bought the securitised assets. This allowed the quantity of money created as mortgages to soar by lowering interest rates (as the perceived risk was low), by raising loan to income ratios, and by expanding the pool of customers to include people with low or insecure incomes (subprime borrowers).
In this phase a further element comes into play. The reckless behaviour of the financial sector was only possible because the traditional separation (dating back from the 1930s) between retail banking and investment banking had been abolished with the Big Bang of 1986, and in 1999 a further boost to dubious financial practices was provided by the repeal of the Glass Steagall Act in the USA: all of this amounted to granting the financial sector an implicit government guarantee. In reality, mixing up speculative activities (the purview of investment banking) with a very basic public service, storing people’s savings and running the country’s payment system (the purview of retail banking) for all practical purposes amounted to giving the financial sector a free licence to abuse the monetary system, as by allowing this change, the government signalled that it was willing to back it up, for the simple reason that it would have no other choice if the situation should run out of control. Eventually the flood of money creation became a tsunami, as a multitude of financial titles (derivatives) based on these securitised mortgages was created, adding a further element of instability to the whole pyramid scheme. Through this process of further multiplication (via derivatives) of real estate based titles circulating in the financial markets, we could say that our housing stock has come to double up its role as collateral both for the banks and for the wider financial sector (or shadow banking system). To sum up:
Privatisation of public housing +public subsidies for BTL landlords + various other incentives = rising demand for privately built houses (and consequent demand for mortgages) + limited land supply = high pressure on prices + deregulation of credit market —> explosion of mortgages = ever rising house prices —> expectations of future price rises —> transformation of houses into assets —> more rise in demand + rise in foreign demand —> more speculation —> more price rises —> larger and easier mortgages —> rising debt pyramid ∆ + flat wages = risk of collapse —> financial innovation + implicit government guarantee —> more speculative demand + more foreign money = more house price increases —> more speculation —> derivatives —> the debt pyramid ∆ gets out of control….
Implications for the economy – boom and bust cycle
As mentioned earlier, there is a huge flaw in this economic architecture: an ever expanding pyramid of debt can only be sustained by expanding wages. However, in our economic paradigm based on outsourcing production, wages are structurally unable to rise. This produces an irreconcilable contradiction:
- Due to low wages, an adequate level of consumption (or aggregate demand) sufficient so sustain an adequate level of economic activity (and thus avoid an economic slump) can only be achieved via the wealth effect (re-mortgaging to finance consumer spending), thus creating more debt and further increasing house prices. This obviously increases the risk of households defaulting on their debts. Therefore the interest of the wider economy towards an increase in the pyramid of debt is in contrast with the interest of the individual households who need to deleverage.
- When households try to do the natural thing, to cut down on consumption and devote increasing shares of their income to debt repayment, so as to reduce their individual risk, they end up putting the whole economy into an even greater risk, that of an economic slowdown. If enough households engage in this de-leveraging activity, the slow down effect may be large enough to cause widespread unemployment, defaults on mortgage repayments, asset price deflation, causing a credit crunch with more reduction of consumption leading to a further economic slowdown which can trigger a further series of defaults, thus putting the entire banking sector in serious danger.
Thus the neoliberal economic paradigm, so cleverly built up by our policy makers, based on low wages and high debt, is prone to generating a dynamic of boom and bust, fitting a pattern known in economics as the Minsky cycle, after the economist who first theorised it (described also in the book Modernising Money, pages 129-139.)
The cycle goes like this: it starts with a situation of low debt and good prospects for the economy. In this situation banks are willing to lend for mortgages. As a result, land and house prices rise, households are forced to take out larger mortgage loans to get on the housing ladder, while existing home owners are able to borrow against the value of their homes to boost their consumer spending. These increased loans boost banks’ profits and capital. The boost in profits and capital enables banks to issue more loans, which further pushes up prices, re-mortgaging and consumer spending. This leads to a booming economy based on debt. This process can continue even when house prices are many times people’s incomes, thanks to the deregulated financial markets, with inception of foreign money and dilution of risk, sustaining the expectation that prices will continue to rise.
The bust part of the cycle arises from the fact that injecting money in the economy in the form of mortgage debt does not lead to a sufficiently higher level of spending able to generate enough new employment an hence higher wages. This is because:
- It has been calculated that only 8% of the money created as mortgages is spent in the real economy: most of this money stays in the financial economy in the form asset wealth. The only part that reaches the real economy is the part that is used to finance consumer spending via re-mortgaging.
- It is debt/money that needs to be repaid, thus lowering future disposable income
- In addition, a further portion of the money spent into the real economy is then used to buy foreign goods, thus further reducing its effect on domestic employment and wages.
Therefore higher and higher amounts of debt become necessary in order to avoid a recession, while the rising debts become ever more unsustainable in the face of stagnating salaries. As the ratio of house prices and mortgage debt to income increases, the economy becomes more vulnerable to any change that would cause a larger portion of people’s incomes to be taken up in debt repayments, such as a fall in salaries or rise in interest rates. Such a change, if significant enough, would see the whole process go into reverse: mortgage defaults, falls in house prices and therefore in people’s net wealth. This would spark a contraction of bank lending, resulting in lower spending, economic recession, further devaluation of house prices that function as collateral for the banks, implying a loss of confidence in the banking system and, potentially, a financial collapse. This is an economic paradigm that cannot afford a substantial recession, because it can easily turn into financial collapse. It is a familiar pattern, and many countries in the past decades have experienced financial crashes that fitted this pattern. What then makes the UK different? Due to the presence of a well developed financial market (= high world demand for pound denominated assets), successive UK governments have been able to implement a recklessly lose monetary policy in order to stave off as far as possible the risk of recession.
The role of monetary policy: the ‘dirty little secret’ & the ‘Great Moderation’
This introduces another element in our understanding of the causes of house price inflation: the role of monetary policy in propping up the pyramid of debt and avoiding a major crash. This is not exactly a policy choice, but a necessity implicit in the neoliberal economic paradigm. For over two decades our central bank (taking the lead from the FED in the USA) has been pursuing loose monetary policies, lowering interest rates in order to postpone the dreaded de-leveraging that might trigger a recession. The official reason for lowering interest rates is of course that this encourages businesses to invest and employ. However, policy makers know that in reality interest rates have little direct impact on business investment, which reacts to aggregate demand instead, (this is what Paul Krugman called the ‘dirty little secret’ of monetary policy in his blog dated 25/10/14), but they have a high impact on households’ willingness to borrow against the value of their homes, thus sustaining their levels of consumption. For over two decades our policy makers have been lowering interest rates every time there was a hint of a recession looming in the horizon, thus incentivizing further household debt and further inflation of the housing bubble. This policy, also pursued by the USA since 1987, has been given a rather misleading name by Ben Bernanke, ‘The Great Moderation’. There doesn’t seem to be anything moderate in the process of inflating asset bubbles, but the term moderation refers to the fact that, by keeping salaries low (thanks to an economic model based on delocalisation and restrictive public spending policies), it was possible to achieve low rates of consumer price inflation, and at the same time to almost eliminate recessions and smooth out (or moderate) the economic cycle, all by means of an extremely loose monetary policy. This was obviously achieved at the cost of an immoderate increase in debt and in asset prices. Essentially the central bank managed to interrupt, by progressively lowering interest rates, all attempts by the private sector to lower its debt-to-income ratio and bring it to a more sustainable level. Eventually, this fake moderation led straight to the financial collapse: when household debt became too large, a few defaults in the USA set off a chain of reactions which the central banks were no longer able to offset with further interest rate cuts.
The subprime mortgage crisis in the USA triggered the much wider financial collapse of 2008. The bankruptcy of the banking system was avoided by means of the bail out provided by the government. In other words, having inflated private debt to breaking point, the government had to take over a large part (the defaulted part) of it and convert it into safer public debt. This major failure of the monetary system was digested and absorbed by both the financial markets and the general public without excessive fuss, and this allowed the monetary authorities to carry on with business as usual. The government debt was then in part reduced with the Quantitative Easing (QE) program (worth £ 375 billions) and the money thus created ended up in the balance sheets of the banking system, allowing them to offset their toxic assets and, once re-financed this way, to resume lending at a sustained pace. The newly created debt has achieved a tentative recovery, at the price of further house price inflation. The only difference with the past is that now the loose monetary policy consists not so much in lowering interest rates (already near zero) and allowing banks to create more debt, but mainly in boosting up the money supply with a substantial amount of liquidity coming directly from the Bank of England, in the form of QE (=positive money) for the banking/financial sector and in the form of a direct subsidy for mortgage loans, the Help to Buy scheme. This means that the Great Moderation continues with a twist: unable to incentivize households to take on yet more debt by means of further interest rate cuts, the government has resorted to add a direct subsidy, in the form of a deposit advance/deposit guarantee. And it has indeed succeeded in increasing both debt and asset prices, thus staving off a worse recession. Many commentators have rightly pointed out that the government is basically trying to solve a crisis due to an excess of private debt…. by creating more private debt!
Method in madness: the logic of the neoliberal economic paradigm
Yet there is method in this apparent madness. We have seen that the house price crisis we are facing now didn’t happen by chance, mismanagement or abuse of the system (although that element is present), but it was simply part of an economic arrangement which has been implemented starting from the early 80’s: the neoliberal economic paradigm. It may have been a completely unsustainable way to run the economy (in absence of some kind of breakthrough leading to a miraculous economic growth), but it was not haphazard or improvised. And for as long as we stick to this arrangement, there is no other way to maintain and adequate level of economic activity (the fabled recovery) than by creating more and more debt.
The core of the problem is in the design of the neoliberal paradigm: by outsourcing production and limiting government spending, employment and wages are kept deliberately low (what economists call wage repression) with the result that the money needed to keep a reasonable level of economic activity necessarily has to come from borrowing and increasingly has to come from foreign debt. It cannot come from wages, for the simple reason that the productive economy has been permanently downsized, starting from the 80s, and the technological change (automation) occurred during this time has further reinforced the trend towards low employment and low wages. This is all within the basic logic of the neoliberal paradigm, which relies structurally on outsourcing production, and structurally produces two adverse consequences undermining it from within: low wages and chronic trade deficits. The resulting shortfall in income needed to sustain consumption is then replaced with debt, and the trade deficits are paid for by attracting capital into the City. Getting into debt, (of which an increasing part is made up of foreign debt), means committing the economy to servicing it, and as the economy becomes increasingly unable to service the debt, increasingly monetary policy has to step in and fuel constant asset price rises via money creation. This is a perfectly logical and coherent model, depressing the price of labour and enhancing the price of assets. It is fantastic for the rich, both domestic and foreign. Its only glitch is that it is unsustainable. This paradigm can only function for as long as returns for capital keep on coming steadily in the form of: interests, rents, profits, if the economy can produce them, and then increasingly capital gains (asset price inflation fuelled by extremely loose monetary policy) and then when the credibility of the whole system is seriously shaken, you need to come up with new incentives by offering ‘extra’ rewards in the form of tax evasion, safety of the investments (in an increasingly destabilised world, both politically and economically), increasing the desirability for world elites to own second homes (or mansions sprawling underground) in London, by adapting London ever more to serving the needs of the foreign elite, rather than the needs of its residents and workers, and so on. All of this is necessary to keep the City of London thriving and to pay for imports. Therefore, all the apparently senseless policies we have seen so far, which have led to escalating house prices, are the consequence of having shifted economic paradigm: from a production based economy to an import dependent economy relying on its ability to attract and reward capital. Basically we have specialised, within the international division of labour, in providing a good place for the rich to store their money and watch it grow from the comfort of their yachts. By downsizing production we have committed ourselves to the service of the rich.
SUMMARY – Importance of house prices for the neoliberal paradigm
We have seen that the problem of rising house prices is a complex one, deriving from a multitude of factors and from a multitude of roles that houses have been progressively charged with, but the ultimate cause resides in having chosen a particular economic arrangement. Within the neoliberal economic paradigm house prices have to rise, and the government has to make sure they rise, for these basic reasons:
- To sustain the credibility of the banking/financial system and avoid another financial collapse – A substantial reduction in house prices can lead to a banking collapse, if borrowers with negative equity start defaulting on their loans. Not only this, with the securitisation of mortgages and the derivatives created on the basis of them, the entire financial sector is vulnerable to the bursting of the housing bubble because a big proportion of financial assets now derive their value from residential real estate.
- To maintain a healthy level of economic activity via the wealth effect – Household spending contributes around two-thirds of GDP growth in the UK, and it is directly linked to house prices via the ability to re-mortgage in order to finance consumption. A downturn in house prices can trigger a major recession.
- To attract foreign capital – in our current situation, with very low economic growth and consequent low interest rates, rising house prices attract speculative capital from abroad, much needed to finance our trade deficits. At the very least we need to maintain the current price levels in order to avoid capital flight.
The price to keep this economic paradigm in place is paid for by ordinary households loaded with ever increasing amounts of debt, and even more by those people (especially the young) who have been priced out of the housing ladder altogether and forced to pay exorbitant rents. Unfortunately it’s not just the investors and the banks who have an interest in high house prices, it is the entire UK economy, including workers who may lose their jobs and pensioners who would see the their pension pots seriously reduced if there is a recession or worse, a financial collapse. Everybody has a stake in this speculative economy, being it the only economy we have…
CONCLUSION – impossibility to reduce house prices without exiting the neoliberal economic paradigm
We have now reached a situation of substantial stalemate, in which the government has to prop up the housing market (and the financial market) at all costs, having to put up with all sorts dysfunctional situations caused by the unsustainable levels of house prices, such as overcrowding and rising homelessness in many areas while prime neighbourhoods in London are reduced to ghost towns, and key workers are unable to live anywhere near their workplaces.
These are the signs of an economy that has tied itself to the service of the rich as it is dependent on their capital. Over time giving returns to capital has involved selling off assets, industries, the welfare state, and then mortgaging future wages and eventually the future income of the state for the bank bail-outs and committing the whole thrust of monetary and fiscal policy to defending the value of assets, while the protection of the state becomes scarcer and scarcer for everything else. Those people, including many ordinary people, who were in a position to jump on the speculative gravy-train early on in this process did get a chance to make some money or at the very least to cover themselves from the effects of dwindling wages and a dwindling welfare system. But for everybody else, and most of all for hose who arrived later in the process for the simple reason that they were born too late, the situation is starting to be seriously uncomfortable.
At the moment we have various sectors of society clamouring for a solution to the housing crisis, and various institutions (starting from the government) pretending they want to do something about it, mostly suggesting ways to boost more construction. However, the proposed measures only intervene on the demand/supply side of the equation, but completely overlook the role that our housing stock plays in the wider economy (as collateral, as instrument of economic policy and as a magnet for much needed foreign capital). It is only by divesting houses of these improper functions that we can start to solve the problem. And to achieve this, we need to exit this economic paradigm based on outsourcing production and creating imaginary value in the City, and work out a more reasonable economic arrangement based on self sufficiency and creating real value in the real economy. At the moment, there doesn’t seem to be any political force willing to expose and to challenge the neoliberal paradigm head on, but there are signs that this may change soon.