Remedies for Ridiculous House Prices

Two of three ways to tame house prices, in the context of the UK's bubble

In my previous post, I suggested three policies which could make housing affordable again:

• “Property Income Limited Leverage” (or The PILL), to limit bank lending to a multiple of the rental income a property could earn;

• An Affordable Housing Authority (AHA), to lend at no interest to buyers can’t get bank loans; and

• A “Modern Debt Jubilee” (MDJ), to reverse the mistake of allowing banks to create as much debt as they wished.

That video focused on Australia’s house price bubble, and the latest Australian government policy designed to keep it inflated.

In this post, I’ll explain how to make houses affordable again, in the context of the UK’s housing bubble.

The UK’s long term data is very informative here, because it highlights just how much the deregulation of bank lending created the housing unaffordability problem that afflicts average income earners today across the world, and particularly in Anglo-Saxon countries.

Firstly, there was no trend at all in UK house prices until well after World War II—see Figure 1. With the inflation-adjusted price index set to 100 in 1980 (the year Thatcher came to power) the house price index was 47 in 1845, and 47 in 1960. House prices rose on average just 0.25% pre year faster than consumer prices between 1845 and 1979, but all of the increase came between 1960 and 1979, when prices rose by 1.75% per year. But after Thatcher came to power, the annual rate of increase in real house prices increased to 3%.

To put that change in perspective, before 1960, house prices rose at the same rate as consumer prices did. At the average rate of relative increase before Thatcher, it would have taken 280 years for house prices to double in real terms. At the rate between 1945 and Thatcher, real house prices were doubling every 40 years. After Thatcher, real house prices doubled every 23 years.

Figure 1: UK long term house prices (https://www.bankofengland.co.uk/-/media/boe/files/statistics/research-datasets/a-millennium-of-macroeconomic-data-for-the-uk.xlsx)

House prices didn’t rise just because The Iron Lady was in charge: it’s what she did.

Before World War II, household debt had been constant relative to GDP: it was 9% of GDP in 1880, and 8.5% in 1947. Most lending for housing was done by Building Societies, and this is crucial, because Building Society loans don’t create money.

Instead, Building Societies have deposit accounts at the private banks, and when they make loans, their accounts fall by precisely as much as the borrowers’ accounts rise.

Banks, on the other hand, increase their assets—loans to households—and their liabilities—household deposits—by precisely the same amount when they make loans. This causes the money supply to expand, and particularly the amount of money used to buy houses. This expands both aggregate demand and incomes, but most of it drives up house prices. Some more houses are built, but overwhelmingly, bank loans make existing houses more expensive.

Thatcher deregulated mortgage lending when she came to power, and banks took over from building societies as the primary lenders. The rate of growth of household debt exploded, and house price inflation took off as well. Household debt increased by a factor of four, from 20% of GDP when Thatcher came to power, to 80% of GDP in 2007 when the Global Financial Crisis hit. Between Thatcher and today, house prices have risen 3.5 times faster than consumer prices.

Obviously “The City” did very well out of deregulating the finance sector. But for average Briton this was a policy mistake, and it should be reversed.

Figure 2: Household Debt (https://www.bankofengland.co.uk/-/media/boe/files/statistics/research-datasets/a-millennium-of-macroeconomic-data-for-the-uk.xlsx)

This is because the deregulating lending set off an obvious vicious cycle: more new mortgage debt causes house prices to rise, which encourages more mortgage debt, which causes house prices to rise. Higher prices mean higher collateral for more lending, and rising house prices encourage speculators to buy houses, rather than people who actually want to live in them. This keeps on going until the rising debt crashes the economy, as it did in the Global Financial Crisis.

Figure 3: Debt acceleration drives house price change (BIS Data)

So that’s the problem. What is the solution?

I can think of three policies—at least two of which are politically feasible, but only if they’re done together. These are “Property Income Limited Leverage” (“The PILL”), an “Affordable Housing Authority” (“AHA”), and a “Modern Debt Jubilee” (“MDJ”).

The PILL and AHA have to be implemented together, because they attack two ends of the predicament we are now in, and they balance each other in terms of their effects on house prices. The PILL would reduce house prices, while the AHA would increase them, and simultaneously enable low income earners to buy a house.

The PILL would limit a mortgage to some multiple of the rental income that the property being purchased can be expected to earn (whether that’s the actual rental income for a property, or the imputed rental income that statisticians). Rents have risen enormously in recent years, but they have still risen far less than both prices and mortgages.

Finding decent UK data is difficult, but with the ratio of London house prices to average annual rental payments being about 25, this implies that new mortgages today would be, on average, equal to about 20 times the annual rental income.

The PILL would start at the current ratio, and then it would be reduced gradually over time, until it reached about 10 to one. This would drastically reduce the leverage currently applied to house prices, and houses would cease being an attractive speculative investment.

Obviously, this would put downward pressure on house prices. That would be politically popular with the majority of the population that is locked out from home ownership today, but it would be politically toxic for property-owning Baby Boomers.

That’s where the “Affordable Housing Authority” comes in. It would put upward pressure on house prices, while simultaneously making it easier for low income households to buy a home. It would do this by cutting out a non-existent middle man: banks.

Currently, the reason that low income earners can’t afford to buy houses is not just that they’re too damn expensive, but also that you have to borrow money to buy them, and pay interest on that money.

According to the Office of National Statistics, the Median household disposable income is just under £37,000 per year, while the median house price is £270,000. If the median household wanted to buy the median house, and somehow scaped together a 10% deposit, then at a 7% interest rate, the payments on a 25-year mortgage work out to £20,600 a year—more than half their disposable income. With housing stress defined as spending more than 30% of your disposable income on housing, they’d be turned down for a loan. That’s why I call banks “non-existent middle men” at this end of the market. You need a bank loan to enter the market, but they won’t let you enter the market if you’re a median income earner.

Figure 4: An Excel mortgage calculator at 7% interest

But what if the median income earner could get a loan at no interest? At 7% interest, more than half the money paid over the life of the loan is interest: interest makes up £271,000 of the £514,000 total. But at zero percent interest, yearly payments total £9,300. That is 26% of disposable income, which is below the threshold for housing stress.

Figure 5: An Excel mortgage calculator at 0% interest

Now, why do banks charge interest? Economics textbooks teach it’s because they’re lending out depositors funds, and since those depositors are doing without their money because of the loan, it’s only fair that they get paid interest in return for foregoing spending themselves. So the interest rate on loans allegedly allows banks to borrow money from their depositors and lend it to borrowers, and then charge a small “intermediation fee” on top.

Figure 6: The textbook myth of Loanable Funds

But, as I’ve explained in previous videos, that’s a myth. Banks do not lend out depositors funds. Instead, they create money when they lend, and they charge interest because that’s how they make a profit. This is the real-world situation: bank loans create deposits—and therefore money—and they charge interest for the service. If they didn’t, they wouldn’t create the money in the first place. They’re in the banking business to make a profit, and there’s no profit on privately-created money without interest being charged on top.

Figure 7: The real world of Bank Originated Money and Debt

But what if there was a lender, the “Affordable Housing Authority”, that didn’t need to charge interest? It would be financed by government money creation. Then, it would lend to buyers who earned the median wage or below—maybe even the average income and below. They would use those funds to buy houses that they currently can’t afford, so the government-created money would go to the house sellers. Finally, the buyers would repay the principal of the loans over the next 25 years. Figure 8 shows these basic operations.

Figure 8: The Bare Bones of AHA

I know that not charging interest on a loan sounds like socialist heresy, so in its defence, I cite two famous capitalists, Henry Ford and Thomas Edison. A century ago, they realised that the main thing that made huge public works projects uneconomic was not the construction costs, but paying interest to the banks on the loan for the construction costs.

Ford and Edison wanted to have the Muscle Shoals hydro electric plant built, and argued that it should be financed by government money creation, at no interest. They realised that, to quote Edison:

“that is what Henry Ford wants to prevent. He thinks it’s stupid, and so do I, that for the loan of $30,000,000 of their own money the people of the United States should be compelled to pay $66,000,000—that is what it amounts to, with interest. People who will not turn a shovel of dirt nor contribute a pound of material will collect more money from the United States than will the people who supply the material and do the work. That is the terrible thing about interest.” (“Ford sees wealth in Muscle Shoals”, New York Times, December 6^th 1921)

Figure 9: Ford and Edison argue for government finance and zero interest payments

Similarly, what is stopping us enabling average income earners from buying housing is the interest they have to pay to banks to buy a house—banks which also “will not turn a shovel of dirt nor contribute a pound of material”. And they won’t even lend to average-income-earners in the first place.

So, let’s cut banks out of a market they won’t even enter. Let’s establish an “Affordable Housing Authority”, finance it via government-created money, and enable working-class and middle-class families to own their homes once more.

Figure 10 shows how this would work. The government decides to create AHA, and finances it exactly the same way that it currently finances spending in excess of taxation: by going into negative financial equity, which creates identical positive financial equity for the non-government sectors. This then enables low-income buyers to purchase houses, and the ultimate financial beneficiaries are the house-sellers. In this way, AHA would counter the effect of The PILL, increasing demand for housing, while The PILL would reduce leverage on bank loans, directly reducing prices that way.

Figure 10: AHA without bond sales

The one drawback at this point is that, without bond sales, AHA would drive the Treasury’s account at the Central Bank into overdraft—and that’s not allowed by current laws. That can easily be addressed by selling AHA bonds to the private banks, just as ordinary Treasury bonds are currently sold to cover deficit spending. This means that banks would get interest income as a side-effect of the policy—which might make them less likely to oppose it politically. And, as applies right now, this interest wouldn’t be an unpayable burden, but government money creation for the banking sector to recompense them for maintaining the payments system.

So this scheme creates winners all round. Most importantly, people who earn less than the average income would be able to buy houses, even given the current ridiculous prices. Sellers, who would lose out from The PILL alone reducing what bank-financed-buyers can spend, would benefit from increased demand from AHA-financed-buyers. Even the banks, who currently don’t earn any interest from below-average-income-earners, because they won’t lend to them given how expensive housing is now, would get interest income on AHA-bonds.

I can’t see Labour or The Conservative bringing in policies like these, not only because they’ve been captured by The City, but aldo because they still believe mainstream economics and its myths like Loanable Funds.

But The Greens, or Corbyn and Sultana’s Your Party, or Galloway’s Workers’ Party? With more than half of Britain’s voting-age population now unable to buy a house, this combination of policies could be an electoral winner. If you’d like to discuss it, just drop me a line!

Figure 11: AHA with bond auctions

That covers the two policies that I think are politically viable. But it still leaves the main problem untreated: excessive private debt. While politicians of all persuasions have obsessed about government debt, private debt is the one that ballooned, and lies behind all—or almost all—of the social and economic problems we experience today.

Figure 12: Private Debt exceeds Government Debt and is the real cause of economic crises

This is where my third policy idea comes in: a “Modern Debt Jubilee”. It’s what we really need: to reduce private debt, but in a way that doesn’t cause an economic collapse. I’ll cover that in my next post—in the context of America’s housing bubble.