The Root Causes of House Price Inflation
Rising house prices are far from being a purely British phenomenon. Comparable rises in house prices across most western economies have mirrored the market conditions in the UK over recent decades. In reality, the influences that drive house price inflation are the same as in any other free market economy and are not unique to Britain, as is often considered to be the case.
Supply and demand dictates prices in a free market but a prevalent misconception of the housing market arises over the basis of demand and from the inherently inflexible nature of supply. The widely held and often promoted assertion is that house prices are driven by demand for accommodation and that with population pressures and finite supply, demand must increase, hence prices must increase. So often is this assertion repeated and so strong the perception that much of the public and media remain committed to the notion of a shortage of supply as an explanation for house price inflation. This philosophy receives understandable acceptance through a population growth widely reported to exceed the supply of new housing.
This common explanation for house price inflation has its basis in relating housing to other commodities and a perceived influence of shortage of supply. However, as evidenced in Spain and Ireland, shortage of supply does not provide a credible explanation for house price inflation. Relative oversupply became apparent in the emergence of ghost towns following collapse of the housing market. Increases to the supply side that exceeded the need for accommodation were ineffective in limiting or controlling house price inflation. Quite clearly, house price inflation was not caused by shortage of supply and increases to the supply side were ineffective in limiting or preventing house price inflation. Similarly, in the UK, repeating historical cycles of house price boom and bust exhibit little or no relation to relative levels of housing stock or demonstrate any dependence on measurable housing shortages. A perceived shortage of supply creates the conditions for house price inflation but it is not the underlying cause. In contrast, house price inflation is governed by demand side influences in the form of speculative behaviour, being merely enabled by the inherent constraints to the supply side.
In a debt funded and tax incentivised housing market, house price inflation arises through the inherent incentive to pursue capital gains through speculation on rising prices, whether homeowner, buy to let or other investor. In a rising market the incentive for profit seeking becomes ever stronger, encouraging greater and greater leverage, driving prices primarily through speculative behaviour and not a lack of supply. A perceived lack of supply, arising from the inherent constraints to supply in response to price increases, acts to further promote such speculative behaviour.
The unprecedented rise in house prices in the UK, US, Canada, Australia and across Europe, trebling over a decade, resulted through such speculative based house price inflation. Such speculation has been driven by the financial and tax incentives, enabled through the supply of easy credit and further encouraged through the emergence of residential property as a purely financial investment vehicle. At its core is the powerful self-interest of personal financial reward.
Through rising house prices and leverage, a property purchased for investment can realise very large and disproportionate returns through the increasing asset value. It becomes possible to generate cash returns equivalent to the efforts of many years of paid employment over the course of just months. Returns are 100% tax free with a modest degree of tax planning and property speculation becomes, for a time, vastly more financially rewarding than employment or alternative forms of investment. Being widely promoted through media, such financial incentive is a powerful motivator and serves to create the basis for speculative behaviour.
Owner-occupiers have the same perception of increased wealth through rising prices although in this instance the increased equity remains tied to a property and does not translate to tangible wealth, other than through subsequent downsizing, relocation or inheritance. The withdrawal of equity through borrowing increases indebtedness and does not create wealth. Although there is not the tangible return as for the outright speculator, owner-occupiers do, however, become complicit in the speculative nature of house price inflation, knowingly or otherwise.
A primary driver of house price inflation comes from the existence of the "property ladder" as an investment strategy: the perceived incentive to seek a maximum asking price and associated capital gain when selling, combined with the willingness to transfer any such gains, coupled with further borrowing, onto a subsequent property purchase under the guise of increasing personal wealth. Such behaviour is speculative in nature but rarely recognised as such on account of cultural familiarity and acceptance. The effect is inflationary and serves to create the self-perpetuating rise in house prices until an eventual collapse from unsustainable debt levels. In contrast, we become only too willing to believe the mantra that house price inflation is caused by lack of supply, as this both justifies the speculative investment and absolves any personal responsibility.
A further powerful driver to financial speculation and investment into residential property has been the establishment of buy-to-let mortgage products. This has increased both the attractiveness and accessibility of residential property for purely financial return. The attraction is a rational one with the potential to accumulate large equity from only a modest initial investment. With rising house prices and leverage, the potential returns on investment increase dramatically through capital growth. Homeowners have consequently chosen to rent out their properties when upsizing. And, more pertinently, the incentive and means to create wider property investment "portfolios" has been created.
As a result, residential property is now viewed as the modern day pension scheme of choice, collectively amounting to over 1.4 million buy to let mortgages. Such additional investment-led rather than need based demand has significantly increased demand side pressures whilst reducing the supply of housing available to purchase as a home.
Pent-up demand pressures come principally from those trapped within the private rental sector. Sufficient properties for this group clearly therefore exist but ownership by investor landlords has denied the opportunity for owner-occupation.
The supply side pressures of mass immigration are also often overstated and misrepresented in relation to the housing market. Migrants tend to congregate in concentrated, less affluent regions and cities and are often willing to tolerate very poor housing conditions. High occupancy rates and substandard housing such as infamous "beds in sheds" significantly lessen the impact on the availability of housing supply. Regions that have not witnessed significant immigration have experienced similar rates of house price inflation, independent to the pressures of immigration.
Governments have always coveted the effect of rising house prices and so have been inclined to promote rather than moderate speculation. Asset price inflation enabled by debt creation and mortgage borrowing generates a "wealth effect". The home-owning majority, with a perceived increase in wealth, become willing to spend more, thereby stimulating growth of a consumer driven economy. Banks' increasing willingness to supply credit serves to sustain the "wealth effect" and support consumer spending. The increasing private debt required to support both consumer spending and the rising costs of housing is a long-term concern and therefore of no consequence to the short-term horizon of politics. Conversely, the compulsion for both partners within a household to seek employment to finance mortgage borrowing is an attractive consequence, ensuring an increased tax base. Stamp duty also offers a useful additional revenue source, with rising house prices and increased sales volumes leading to increased tax revenues.
Of course, MPs typically fall into the (multiple) homeowner bracket, so those who have influenced housing policy are also likely to be those who have a strong vested interest in rising house prices.
It is Government, whose purpose it is to regulate markets for the benefit of society at large, that has failed, encouraging speculative based house price inflation motivated by short-term interests. Individuals cannot be reasonably criticised for pursuing self-interests and seeking to prosper from the opportunities that are made available. Effective governance, however, requires policy making to place wider benefit before self-interest in order to establish the conditions for equality and long-term prosperity.