Why is housing in the UK a distorted market? To see more of our products visit our website at Nigel Watson

e In a free market price is determined by the relative strength of supply and demand. Price signals from consumers are sent to producers, which are responded to out of self-interest. Those who take a laissez faire point of view believe governments should not intervene in markets as it will prevent the invisible hand functioning effectively. Introduction The UK market is not free, because government and central bank intervention has affected both supply and demand, creating a dysfunctional market. In most cases intervention has kept house prices higher than they might have been, which we could call an unintended consequence.

e Most houses are bought with borrowed money via a mortgage, secured against the property. From time to time some borrowers cannot keep up the payments and default, commonly due to redundancy. After a default, banks will try to recoup the money owed to them by repossessing the borrower’s house. Repossessions case the supply of housing to increase, causing price to fall, other things being equal. Policies used to restrict the supply of housing : Lender forbearance 1

e Relatively few houses have been repossessed during the recent recession even though unemployment has increased sharply. This was partly due to the bailout of the banks by the government, who asked them to be more lenient with homeowners who could not pay their mortgage. This has stopped the supply of housing increasing by as much as it might have done and prevented house prices falling further. Policies used to restrict the supply of housing : Lender forbearance 2 In July 2011 there were 760,000 UK mortgage borrowers benefiting from this mortgage forbearance.

e The number of repossessions and hence housing supply, has also been reduced by Support for Mortgage Interest (SMI) This was a new benefit for unemployment homeowners, whereby the government paid recipients just over 6% of their outstanding mortgage debt each year. This was a very generous scheme with 92% of claimants receiving more than they actually needed. Policies used to restrict the supply of housing : Support for mortgage interest The new coalition government have reduced the rate to 3.6%.

e Funded by local authorities this scheme stops houses in default going onto the open market by allowing not-for-profit housing associations to buy them up. The housing association then allows the former owner of the house to rent it from them. This has definitely reduced the number of repossessions which has supported house prices by restricting supply growth. Policies used to restrict the supply of housing : Mortgage rescue scheme

e Fewer houses are being built each year compared to the growth in the UK population. In June 2010 the government tightened planning laws, and thus the supply of new housing, by preventing the conversion of urban gardens into building plots. Should planning regulations be relaxed in the UK? This might help boost housing supply and bring property prices down in the short run, and would prove popular with first-time buyers. Policies used to restrict the supply of housing : Restrictive planning laws However, lower prices would reduce the book value of banks’ assets, making the banks appear less solvent. But conservation groups would be very concerned at any relaxation.

e Equilibrium prices in a specific micro market can be propped up by policies that increase demand. In the UK the government and the Bank of England have intentionally or unintentionally used policies to support demand for housing. During the recent downturn the demand for houses has decreased, but the fall in demand and the associated fall in house prices have not been as great as they might have been. Policies which have artificially boosted housing demand: Introduction We can identify three factors at work: low interest rates, housing benefit and financial deregulation.

e The Bank of England is supposed to set interest rates to achieve a symmetrical inflation target of 2%, with 1% margin of error on either side. Interest rates in November 2011 remain at an all-time low of 0.5%, despite the fact that inflation has been above target for over 50 months out of the last 60. The Bank has argued for the last four years that current above-target inflation is only temporary. Policies which have artificially boosted housing demand: Record low interest rates Low interest rates reduce the cost of borrowing and increase the demand for houses bought with mortgage debt. However, if higher interest rates had been brought in to reduce inflation, there would probably have been carnage in the housing market.

e Housing benefit is paid to people that do not earn enough to pay their rent, and in December 2010 was paid to a staggering 4.8m people living in the UK. The £400m per week plus which has been thus injected into the rented property market has boosted rents, and therefore, yields for landlords. This is turn has boosted demand for houses amongst Buy-to-Let property investors. Policies which have artificially boosted housing demand: Housing benefit The coalition government has announced plans to cap housing benefit, but if it was abolished, rents would fall dramatically. This would cause the demand for housing to decrease and house prices to fall.

e As most houses are bought using a mortgage, the main factor determining the effective demand for housing is the availability of credit. However, the housing bubble was fuelled by a relaxation by lenders of mortgage lending standards, coupled with some fraud. This resulted in many borrowers defaulting and led to record banking losses. Policies which have artificially boosted housing demand: Financial deregulation Banks responded by being more prudent and house prices fell by nearly 20% between , as a result of a decrease in mortgage lending. The government is now encouraging banks to return to ‘respectable lending’ to get the housing market moving again.

e House prices in Ireland have fallen by more than 50% and there have been similar crashes in Spain, America and Greece. So far, government initiatives and record low interest rates have prevented a crash of similar magnitude in Britain. Yet house prices in the UK are still well out of line with household incomes. Can the government and the Bank of England still buck the market and prevent a British house price crash? Conclusion