UK House Prices,
Consumption and GDP
in a Global Context
Andrew Farlow
University of Oxford
Department of Economics, and Oriel College
John D Wood & Co.,
The Cavalry and Guards Club, Piccadilly,
London, 20 January 2005
This is based on a paper to be found at:
http://www.economics.ox.ac.uk/members/andrew.farlow
(Syntax slightly improved post-presentation to make the slides more easily
readable given the lack of a presenter)
Today’s Presentation:
Part Three of Five Parts

Part One: “UK House Prices: A Critical Assessment”

Part Two: “Bubbles and Buyers”

Part Three: “UK House Prices, Consumption and
GDP in a Global Context”

Part Four: “Risk Premia and House Prices”

Part Five: “Mortgage Banks and House Prices”

Book: February/March 2006, Publisher: Constable
Robinson
UK historically strong housing
cycles
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Strong housing market cycles, linked to volatile
consumption, have been an overriding feature
of the UK economy for over three decades.
OECD (2004): 1971-2002, UK the strongest
correlation of housing wealth and GDP of any
country surveyed.
IMF(2004): The UK (along with Finland,
Ireland, and Switzerland) has had one of the
most procyclical housing markets in the world.
Something more global this time?
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Something extra this time: The “first global
house price bubble” (The Economist)?
Small probability large loss events matter.
Even if only a small chance, we should analyze
the possibility.
IMF, 2003 World Economic Outlook, 40% of
booms followed by busts, and 8% cumulative
GDP loss.
State of housing markets, part of a bigger
picture of global imbalances?
UK House price falls and GDP
falls

No fall in real house
prices (blue line) not
followed by major
fall in UK GDP
(gray bands)

Will the pattern
repeat?
Source: Bank of England Inflation Report, May 2004, p7, Chart 1.10.
Consumption and House Prices

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1970-mid 1990s, rapid
increase in house prices
(green line) accompanied by
rapid growth of
consumption (red line)
Recently, house price
inflation has accelerated but
the rate of growth of
consumption has steadied.
Source: Bank of England Inflation Report May 2004, p12, Chart 2.1.
A breakdown?
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Misleading causation.
Both driven by income expectations? Not
directly observable.
Credit constraints?
A very different central bank response next
time?
More evidence: durables and nondurables

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Real durable and
semi-durables
consumption is highly
pro-cyclical.
But need to adjust for
rapid price falls…
Source: Bank of England Quarterly Bulletin, Spring 2004, J Power, Chart 1.
Nominal ratio of durable to nondurable consumption
Source: Bank of England Quarterly Bulletin Spring 2004, J Power, Chart 11.
Real house prices and share of
durable spending in consumption
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Source: Bank of England Inflation Report November 2004
Durables more likely
purchased on credit.
Share previously very
correlated with house
prices.
Correlation has
broken down since
the late 1990s.
More Evidence

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Swings in spending
relative to income – in all
periods - of
homeowners is nearly as
great as renters.
But: risk premia and
options thinking of
owners, etc.
Source: BOE Inflation Report May 2004, p12, Chart 2.3, based on the Family Expenditure Survey.
Possibilities

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Credit constraints less important?
No upwards revision in expected future earnings
and wealth?
This would have driven higher housing demand (and
house prices) and higher desired stock of durables.
 Flow increase in durables expenditure on the path to
new desired stock level.

Awkward Conclusions
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If real income expectations are pretty stable, how could
these have driven house prices so much higher?
Not enough ability of demographic factors and the
slow rate of house build to explain house price rises.
Great deal of weight placed on a credit constraint story
for house price rises.
But difficult to create a consistent story if credit
constraints are highly important for housing
consumption but not for non-housing consumption,
especially durables.
Or…

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Very high real house prices (and/or low interest
rates) are not regarded as long-term sustainable
by the general public?
Also some distributional issues – since rapidly
rising house prices (relatively) redistribute wealth
from asset-poor to already asset-rich, from
young to old. And this feeds subtle differences
in aggregate consumption behaviour.
Mortgage Equity Withdrawal
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Source: Bank of England Inflation Report May 2004, p 13, Chart 2.4.
0% of household
income in the late
1990s
Now over 8% today
Yet, consumption as a
percent of household
disposable income has
hardly changed (1997today)
What if MEW were
to collapse this time?
Correlation between annual
house price inflation and annual
consumption growth
Source: Bank of England Inflation Report November 2004, p12 Chart B.

10 year rolling correlation coefficient has collapsed
Need to correct for…
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Demutualisation of building societies. Windfall
payments (fungible with MEW) of £35 billion,
or 7% of annual consumption, helped the jump
from 90% to 96% in two years with hardly any
change in MEW.
Introduction of self-assessment.
The relationship is still weaker than in the past
but nevertheless is more positive than it first
appears.
The big consumption story?
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Levels v. stocks: The surge in the level of consumption
from 86% to 96% of household disposable income
created high rates of growth of consumption in the
1980s.
Recent consumption has run consistently at a much
higher level for much of the last 7-8 years (with 3%-5%
consumption growth per year).
The big consumption story of the late 1990s and early
2000s is the historically high level of consumption from
disposable income, low levels of savings, and
deteriorating pension provision.
More on MEW
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Insignificant in the UK
up to 1980.
1980s liberalization.
No other country in the
EU ever managed
anywhere near to 8%.
1979-1999 Germany,
France, and Italy net
injection of 6% of
household income into
housing.
Source: Bank of England, Office for National Statistics and HM Treasury calculations. Chart 5.5, HMT 2004 p52, not updated.
Key MEW findings
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50%-60% is last-time sellers and those trading down,
i.e. those most likely to pay off debt and save.
A large proportion that is spent goes on ‘home
improvement’ and ‘new goods for the home’.
But, house prices and MEW are partly endogenous to
any price bubble (family transfers, home improvement).
Borrowers who withdraw to spend are concentrated at
higher incomes, but a sizeable proportion are on low
incomes, and their borrowings are relatively high-level.
Low levels of serial remortgaging.
MEW and housing market
Transactions

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UK has one of the
highest rates of
housing market
transaction in the EU.
Transactions volumes
matter if most current
MEW is released
through last-time sales
and trading down.
Source: HMT Table 5.4, p51. Source: Bank of England and Office for National Statistics.
MEW cont.
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MEW is more lumpy than many credit constraint
stories suggest, which is why so much MEW is
immediately saved and then generates a later flow.
Much of the consumption flow from recent MEW is
still to come. More stabilizing?
If MEW plummets, there is no new flow into the stock
of assets to generate new consumption flow. Less
stabilizing?
In ‘turning’, or stagnant, housing markets price does
not fall heavily at first; transactions do. The liquidity of
the market and ability to ‘release’ equity falls.Those
wanting to trade-down are heavily dependent on chains
of buyers. Their ability to release MEW falls.
But…
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Only element of MEW that seems not cyclical is
remortgaging (but evidence is hard to interpret).
For those forms of MEW that involve
borrowing…debt bites much more in a low inflation
environment.
What if those borrowing on MEW are excessively
buying into the house ‘price rise’?
If MEW replaces ‘more expensive’ forms of
debt…this dries up if house prices fall.
A small consumption response can still be magnified by
a big collapse in MEW.
If prices fall, there will be a collapse in MEW.
Demographics of MEW
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Withdrawal of equity by last-time sellers is much
greater than injection by first-time sellers. Stock of debt
naturally rises over time.
If house prices are overvalued, those at the top have
been removing more equity than they would have done
in a less overvalued market, leaving behind on average
more indebted households.
Price bubbles are highly redistributive.
Price bubbles are popular with voters, and politicians.
Element of being a ‘Ponzi’ game.
MEW is not the main story
Savings and pensions are!
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State of the housing market, level of savings, and
‘pensions crisis’ are linked.
Global liquidity story too.
If consumers believe that rapidly rising prices are
sustainable…then they may believe that current
consumption can be run at very much higher levels
than in the past.
Shocking evidence of unrealistic price expectations.
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(Case, K.E., Quigley, M., and Shiller, R.J. 2004)
Slack taken from other parts of the household balance
sheet, and over-reliance on housing to generate future
pensions provision.
What about non-MEW…

If many of those withdrawing housing equity
are not immediately spending, what are nonMEW consumers doing to maintain
consumption consistently at 96% or more of
income?
Low savings;
 Eating into pensions contributions they ‘should’ be
making;
 Non-MEW forms of debt;
 Relying on house prices? Some notion of ‘asset value
allusion’. Housing wealth fungible with other forms
of savings? The cheapest form of credit?

Saving ratio
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Shows UK households’
saving ratio and house
prices (plotted with
negative of saving ratio)
Paradox of thrift too in a
major correction.
Source: HMT 2004, Chart 6.3. p. 60. Source: Office for National Statistics and Office of the Deputy Prime Minister.
Saving ratio cont.

Source: HM Treasury, 2004, p64.
Correlation between
saving ratio and
house price inflation
one period earlier
Impact of interest rates on house
prices and consumption
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EITHER house prices are less volatile than in the
past…
OR, if they are still just as volatile, the links to
consumption are weaker…
OR, interest rates can cope with any problems (ease
cash-flow problems, cushion/slow house price falls,
etc.)
Direct and Indirect effects of interest rate changes via
housing market:
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both have forces working for and against;
Both are difficult to be precise.
Conclusions on direct and
indirect effect
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The direct effect of reducing interest rates after the last
house price crash was large. Likely more modest today.
The Bank of England should worry less this time when
raising (or holding high) interest rates, but also feel less
confident of the power of rate cuts to make a big
impact on aggregate cash-flow.
Indirect effect stronger, but not much interest rates can
do if large speculative aspect to house prices.
But many caveats, including:
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Distribution and fragility of debt is not fully clear.
Caution;
Credit conditions generally;
Dangers of moral hazard if perceived to be ‘bailing out’.
Redistribution effects of
falling/rising house prices
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Rapid house price rises have similar consequences to
sustained budget deficits, depressing the current real
productive capital stock in exchange for current
consumption by the gainers.
House price booms, just like government budget
deficits, are popular with older consumers (and younger
bubble-motivated consumer who ‘know no better’, or
suffer asset price allusion).
Like deficits, older consumers benefit from the
‘borrowing’ from future generations, even as long-term
income levels are reduced due to the crowding out of
real productive capital stock.
Distributional issues suppressing
long-run values

Depressing influences on the investment potential of
housing of the current generation (since the market for
the value of their homes is the next, smaller, more
burdened generation) include:
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demographically aging population;
falling cohorts in younger generations;
record low savings;
deteriorating provision for retirement;
the burden of social security and health increasing over
time.
Still overvalued…
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This and other analysis (risk premia, etc.)
suggests the market is still overvalued.
Given current overvaluation, the real rate of
return on housing for, say, the next 20 years is
much lower than the historical average of about
2.5% (indeed, zero is within the 95% confidence
interval for the 20 year real rate of return).
It also suggests that if correction is inevitable, it
is not obvious that correction should be resisted.
Global House price correlations
and global liquidity
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Highly synchronized positive movements in house
prices, and global build up in mortgage debt.
An extremely recent phenomenon that does not affect all
countries equally:
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US, Australia, UK, China, France, Ireland, New Zealand,
South Africa;
Relatively few EU countries.
The correlation between real house prices and output
(and consumption) has declined since the mid-1990s,
reaching unprecedented low levels by 2003.
Potential for instability from outside UK

Hence issues of timing, interest rate decisions, etc.
Variance decomposition of house
prices
Source: IMF 2004, data from: Haver Analytics; IMF, International Financial Statistics; national sources;
OECD; and IMF staff calculations.
UK case

House Factor and Global Factor over time, per cent
change, constant prices, demeaned
Source: IMF 2004, data from: Haver Analytics; IMF, International Financial Statistics; national sources; OECD;
and IMF staff calculations.
UK decomposition of house price
change over time
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Source: Extracted from IMF 2004
Orange = Actual
Blue = Global Housing
Factor
Red = Global Factor
Black = Country Factor
Global Liquidity
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Global driving forces – especially US house prices, US
interest rates, and global liquidity.
25% per year growth in the sum of America’s cash and
banks’ reserves held at the Fed, and in the foreign
reserve holdings of central banks around the world.
Excess liquidity in the past flowed into traditional
measures of inflation (goods and service prices).
Does extreme liquidity show up in asset price inflation
– house prices – and record high global levels of debt,
especially mortgage debt? Overreaction after stock
market crash?
US housing stock has risen in paper value by $5 trillion,
almost precisely matching the $5trillion of lost stock
market wealth of the early 2000s.
Did Global interest rates go too
low?
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Natural rate of interest: the rate at which the supply of
savings of households exactly balances the demand for
funds by firms for investment purposes.
Natural rate is roughly equal to the rate of inflation
plus the real trend rate of growth.
Natural rate moves about according to:
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technological improvement;
changes in preferences;
the impact of demographics on the need for savings, etc.
If cost of capital set below this, get overcapitalization,
the level of borrowing and investment will be excessive,
saving too low, and the chances of bubbles greater.
Natural rate too low, continued
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For UK about 5% (2% inflation plus 2% to 3%).
Global natural rate (difficult to work out precisely) may
even have risen (China, IT, global integration, inflation
success, etc.).
Yet, some of these forces have also lowered inflation
and even encouraged lower interest rates.
And bubbles encourage households not to save, making
things worse.
Low rates followed collapse of late 1990s and various
other crises/collapsing bubbles.
The US
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US (especially) interest rate kept below ‘natural rate’ for
too long? 3% to 5% too low? Maybe after previous
bubbles? Went from 6.5% in 2001 to 1% in 2003.
Past five years America’s national spending has
exceeded its income by about a fifth.
Private debt has boomed (nearly $10trillion).
Savings have hit 0.5% (compared to historical average
of 8%). Sometime, a reversion back to 8%?
Private debt service is historically high – even before
interest rates rise.
US cont.
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US government has joined US citizens. Approx
$450bn budget deficit per year.
Externally held portion of debt risen from 20%
to 45%.
Problems with ‘depth’ of US mortgage markets.
Problems with US ‘lender of last resort’.
US cont.
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If a country has strongly favourable investment
opportunities – that will ultimately make its inhabitants
much better off – it is economically rational to
consume some of the fruits now, borrow from the rest
of the world, and repay from higher output later.
Meanwhile, run a strong currency and high trade and
current account deficits that generate a net capital flow
equal to the current account deficit.
However, decomposition of US data shows that debt is
currently largely being used to finance public and
private consumption, rather than investment.
Asia and US mutually reinforce
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Global foreign exchange reserves have doubled since
the Asian crisis of 1998, to $3,800bn, with two-thirds
of this in dollars. Asia accounts for 80% of this growth
and now has 70% of global reserves.
Reserves account for 9% of global gross domestic
product, compared to less than 2% during the pre-1971
Bretton Woods era.
High demand for US debt may be a response to
previous crises. It has chipped 0.5% to 1% off US
yields. It has helped the US to run large government
and trade deficits.
China has chipped 0.1% to 0.3% of US inflation
(maybe as much as 1%).
In turn, China’s boom has been helped by low US rates.
House price contagion?

If sufficiently strong house price falls in one country
(for example, rebalancing in the US will require lower
spending on housing consumption) or several countries
generate a decline in consumption for them, then it is
more likely that consumption will fall in other countries
too:
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Real contagion (via consumption).
Financial contagion (via, in particular, mortgage bank
and government balance sheets).
Equity-based bubbles less damaging than debt-based
bubbles. Has mitigating the first, led to the latter?
See Farlow, “UK House Prices, Consumption, and
GDP in a Global Context,” Section 6, for scenarios for
correction.
Impact on UK policy

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How do these possibilities affect our attitude to falling
house prices in the UK and central bank policy on
interest rates?
If rebalancing of the UK housing market is inevitable,
this suggests allowing rebalancing to proceed sooner
rather than later – leaving the housing market in a
better position to withstand global disturbances
consequent on rebalancing elsewhere.
Reversion to fundamentals, while it harms
consumption, at least conceivably puts the economy
back on a footing that emphasizes real economic
activity over speculative housing activity and ends the
distortions that lead to long-term pension and saving
misallocation.
Lessons for the UK
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Global instability might matter more for UK house
prices than is perhaps currently accepted. The fate of
the UK housing market may currently be one of the
less domestically controllable aspects of UK
macroeconomics.
The Bank of England has faced an unenviable choice
between trying to turn the tide of house prices and not
sacrificing growth and risking under-hitting its inflation
target.
Emphasis on controlling the housing market has to
include reforms and not just rely on interest rates.
Lessons for UK cont.
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Interest rates may have little power to influence house
prices in a price collapse anyway. Trying to generate a
cash-flow affect to offset a wealth effect caused by an
unwinding bubble may simply not work very well.
Handling global surges in house prices might need
more of a coordinated response than it probably gets,
or is ever likely to get.
Stop-go cycle via house prices in place of stop-go cycle
via goods and services prices?
Bubbles confuse inflation signals

Recent asset price bubbles might have helped to
dampen up-front inflationary pressures. In case of
equity market bubbles:

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Artificially boost profits as measured in standard
accountancy measures – firms adopt more aggressive
pricing strategies;
Positive feedback via capital accumulation and
favourable supply-side developments, especially
productivity gains, the spreading of technology, and
‘catch up’ in emerging economies (c.f. China), with
consequent lower inflationary pressure;
Firms able to make much lower contributions to pension
schemes (and employees willingly accept, c.f. US 1990s);
Employees tolerate less inflationary wage claims given
perceived gains on stock market investments (especially
evident in the US in the late 1990s);
Bubbles confuse signals, cont.

Governments benefit from bubble-inflated asset prices
that inflate the tax yield (stock market taxes at the end
of the 1990s, housing transactions taxes, consumption
taxes, low use of pension tax allowances, etc. in current
housing bubble) and allow them to run lower tax rates
than otherwise would be the case, even as their fiscal
positions are strengthened;

When the bubbles unwind, all these things go into
reverse – just at the wrong time.
A public sector generated cashflow shock?

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There are dangers in running a fiscal policy that risks a
sudden tax increase in the face of a declining housing
market (maybe at the same time as a swing in global
credit conditions).
This time, the impact may show up more than usually
as a public sector cash-flow problem.
But burdens for the public sector are ultimately private
sector burdens. It is simply an issue of timing.
If house price falls are slow enough, this cash-flow
problem can be offloaded to the private sector at a
more timely pace.
Public sector cash-flow, cont.
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If price falls are more rapid (and confidence takes a
greater hit) then the cash-flow difficulty (or even just
expectations of it) may be fed much more quickly to
the private sector – especially in the form of higher
taxes – reinforcing the private sectors cash-flow
problem and putting downward pressure on house
prices. The economy finds itself on an even higher tax
trajectory at quite the least opportune time for it.
And tax rises are hard to target on the relatively less
indebted (unlike interest rate falls).
Growing tension between Bank of England and
Treasury.
Precarious balancing act for
central banks

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If rates are raised too slowly, any momentum-driven
bubbles will expand even further, financial imbalances
intensify, with inflationary pressures built up for the longer
term. Adjustment is simply delayed till a point when the
fragility is even greater and when the dangers of triggering
a switch to deflation are higher.
If rates raised too quickly, fragilities may unwind too fast.
Balancing act for debt holders too.
This time real price falls will need nominal price falls.
This time the Bank of England would not allow the runaway inflation needed to create the negative real interest
rates that would generate a similar situation today to that
easing previous price collapses.
Central bank difficulties, cont.

Interest rates may have too much to do and be unable
to fall as far as the housing market might require:


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
If the pound were to weaken too quickly;
OR oil or commodities prices rise too strongly, feeding
UK inflationary pressures;
OR the US were to suffer a fiscal crisis and sudden
swing in sentiment forcing it to raise real interest rates
much higher in defense;
OR UK government finances were to deteriorate quickly
as lower confidence and economic activity reduced the
tax yield.
Rising spreads may keep interest rates off the floor.
System has not been stress-tested yet. Best to set so as
to minimize the fall-out from mistakes.
Central banks cont.

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

Policy in the late 1990s settled on price stability via
interest rate adjustments and not tax adjustment, since
easier to set up an institution independent of elected
government.
Danger that governments rely on – even over-exploit –
the policy credibility created by central banks.
A slow revision upwards of interest rate expectations is
better than a sudden unexpected tax rise. Gradual
reversions without surprises are best.
Openness about interest rates – and at least the chance
for households to think the scenarios through and
factor higher interest rates in – contrasts sharply with
the complete lack of openness about (and the political
nature of) the timing and level of future tax rises.
A Few Summary Thoughts

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Global rebalancing at some point.
Expected consumption and GDP response will matter.
Much of the analysis of the consumption response is
based on efficiently operating bubble-free markets.
Once we allow bubble mispricing, consumption
responses are generally not well captured.
Soft landing is not fully convincing when a broad
picture of consumption is considered, including
pension and savings, and when levels as well as changes
in levels are reviewed.
Continued on next slide…
A few summary thoughts cont.

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
Debt-backed housing bubbles probably more damaging
than stock market bubbles.
The new stop-go cycle?
Politicians love to exploit bubbles.
Aftermath of current period likely to focus attention
on a wide range of issues. Many of these require
coordination across diverse economies, something
usually achieved more easily in stable times. In less
stable times, something much easier to handle if some
thought has gone in ahead of time.
Being better educated helps. Caricature of ‘optimists’ or
‘doomsters’, ‘experts’ or ‘pundits’ does not help.
THIS IS THE LAST SLIDE