THE UK HOUSING MARKET: REFORMS VITAL TO CURB VOLATILITY AND PREPARE FOR EMU
The volatile and speculative nature of the UK housing market has important consequences for the economy, and especially for our ability to join EMU. In ESRC-funded research published in the November issue of the Economic Journal, Professor John Muellbauer and Dr Anthony Murphy explain why booms and busts occur and how the housing market might be reformed to facilitate UK participation in EMU. They conclude that the introduction of a significant property tax based on current market values is likely to prove essential.

Muellbauer and Murphy find that the volatility of UK house prices has much to do with the high gearing permitted by mortgage lenders; the low transactions costs (for example, stamp duty and estate agents’ fees); and a history of positive investment returns, which encourages people to extrapolate recent experience.

Together with high levels of home ownership and the small size of the house rental sector, these factors imply bigger UK effects of rising housing wealth on consumer spending than in continental Europe. In addition, the dominance of floating rate debt in the UK suggests that the UK business cycle tends to be more volatile and that interest rates affect the UK economy differently.

Muellbauer and Murphy estimate an annual model of UK house prices to explain why booms and busts occur. The 1980s boom, for example, saw a 40% rise in house prices relative to incomes in 1981-89, and large investment returns to heavily-borrowed first-time buyers. Many factors contributed:

Initial debt levels and house prices were low, giving scope for rises in both.
Income growth and expectations were strong and the effect of the latter was enhanced by financial liberalisation.
Financial liberalisation allowed households to ‘gear-up’ by borrowing more than previously possible.
Financial assets grew relative to income.
There was stronger population growth in the key house-buying age groups.
The supply of houses grew more slowly with construction of social housing falling to a small fraction of its level in the 1970s.
The proposed abolition of property taxes in favour of the Poll Tax increased the attractions of property.
Recently experienced positive returns created expectations of further gains.
Finally, in 1987-88, interest rates fell.
The bust in the 1990s, which resulted in massive falls in house prices relative to incomes, and hugely negative rates of return, was due to the reversal of almost all these factors. Interest rates rose in 1988-90; income growth and expectations weakened; previous demographic trends weakened; and the revolt against the Poll Tax led to a new property tax, the Council Tax.

Debt levels and house prices had reached very high levels, while the experience of negative rates of return made households and lenders more cautious. Under these conditions, not even the big falls in nominal interest rates in 1990-93 were sufficient to revive UK house prices by 1995.

In the last year, house prices in the South East have risen over 20% led by rising incomes; share prices; foreign demand at the upper end of the market; and the fading out of the ‘fear factor’. Relatively high debt levels, high real interest rates and the falling population share in the main house-buying age groups should dampen the recovery, but the momentum already built up suggests further rises to come.

The important implication of Muellbauer and Murphy’s research is that even if the UK business cycle moves into phase with its European partners’ cycles, a different interest policy may still be called for. If it is inevitable that the UK joins the EMU project, some UK reforms will be necessary to reduce these problems.

These could include higher stamp duty to make housing less tradable; tougher prudential controls on lenders; and a significant property tax based on current market values, which would automatically take cash from households when house prices rise strongly. But higher stamp duty damages mobility while major tightening of prudential controls is not feasible in today’s liberalised financial markets. Reform of property taxes is therefore likely to prove essential.

Note: ‘Booms and Busts of the UK Housing Market’ by John Muellbauer and Anthony Murphy is published in the November 1997 issue of the Economic Journal. Muellbauer is Professor of Economics at Nuffield College, Oxford, OX1 1NF; Murphy is Senior Lecturer in Economics at University College Dublin. Their research was supported by the Economic and Social Research Council (ESRC).

For Further Information: contact John Muellbauer on 01865-278583 (fax: 01865-278557; email: john.muellbauer@economics.oxford.ac.uk); or RES/ESRC Media Consultant for Economics, Romesh Vaitilingam on 0171-878-2919, 0117-983-9770 or mobile 0468-661095.