Authors: David Smith
Rising incomes pull house prices higher and incomes have risen steadily, and by about 2 percent a year more than inflation (in other words in ‘real’ terms) for as long as anybody can remember. If we go back forty years, average earnings were a few hundred pounds a year. They have risen twenty-five-fold while prices have increased fifteen-fold. Certain groups of workers, of course, do better than others. I am old enough to remember the first £100-a-week professional footballer. Now the top-paid players get nearly £100,000 a week. I shall return later to the reasons why earnings usually rise faster than prices. One entertaining way of demonstrating that they do is by reference to the time an average person has to work to earn enough to afford certain products. Thus, in 1900 the average worker had to toil for a couple of hours to earn enough to buy a loaf of bread. Today it is about five minutes.
There is also an institutional element in the relationship between house prices and incomes. Banks and building societies base their mortgage-lending decisions on the income, and therefore ability to pay, of the borrower, offering an advance that is a multiple of annual salary. That multiple can be as high as four, five or six times the salary, although the average is only just over two. Interestingly, the ratio of house prices to incomes is usually significantly higher for older people, who have been homeowners longer, than for first-time buyers. This is because, while for first-time buyers the mortgage covers a high proportion of the value of the property, longer-term homeowners have usually built up capital, or ‘equity’, in their house. Someone buying a £25,000 house on a £20,000 mortgage has £5,000 of equity. If the value of the house rises to £100,000, the amount of equity increases to £80,000. There is, incidentally, little evidence that the housing market has become progressively more difficult for first-time buyers to enter, particularly when the level of interest rates is taken into account, of which more below. Indeed, the opposite may be true. In the past – until the early 1980s – when mortgage lending was limited to the building societies and rationing was common (societies had to have enough income from savers to lend out in mortgages), entering the market was a long and tortuous process.
I said the housing market is different. Why, as in our potato example, do house-builders not respond to high prices by flooding the market with new houses? And why does this not bring prices down, as it would for other products? The answer is that new houses account each year for only a tiny proportion of the existing housing stock. Land, to go back to some of those definitions at the start of this chapter, is a scarce resource. And planners ensure that, as far as building is concerned, it remains so. If there were no planning restrictions and any farmer could sell a few fields for housebuilding, the housing market would be more like the market for potatoes. Big increases in supply would, from time to time, be followed by significant price falls. The planners, by preventing this from happening, help ensure rising house prices. The year 2000 was, on the face of it, a strong one for the housing market, with prices rising quite markedly and mortgage demand buoyant. It was a weak one, however, for housebuilding, which dropped to its lowest level since 1924, the industry blaming planning rules intended to prevent development of greenfield sites. Housebuilding fell even further in 2001. It is possible to stretch available living space a little, by converting houses into flats, or offices and former factories into fashionable lofts. But the general point still holds. New supply is very small in relation to the size of the market. To economists supply is ‘inelastic’ – it responds only slowly to rising prices – whereas if builders were able to flood the market with new properties in response to high prices it would be ‘elastic’.
Two prices for housing
We have got this far without touching on something rather important as far as housing is concerned, and there is just time to talk about it before the next course. When people talk about their house, they usually know how much they paid for it. They usually have a rough (sometimes a very precise) idea of how much it is worth. But, as every homeowner knows, as important as the price is the monthly mortgage outlay and that, in turn, depends on the level of interest rates. An easy way of demonstrating this is as follows. Suppose I buy a house for £100,000, on a full repayment mortgage, and pay for it over twenty-five years at an average interest rate of 10 percent, the total cost to me in monthly payments over the period is £275,418. If, on the other hand, the average interest rate were 5 percent, repayments over twenty-five years would be £177,381. The difference is nearly as much as the original price of the house. Before anybody jumps up and down, £100,000 now is clearly worth more than £100,000 spread over twenty-five years. Newspaper competitions sometimes offer choices of prize money in the form of either a large amount upfront or a somewhat smaller amount paid weekly for life. There are few takers for the latter. The economic principle behind this is similar to the old proverb: ‘A bird in the hand is worth two in the bush.’
Suppose you had the choice between £100,000 now or £200,000 spread over twenty-five years, which would you take? Before you opened this book your instinct may have been to go for the larger sum. Armed with some economics, however, the kind of calculation you would make would focus on the rate of interest you could earn on that money over the period. At a 4 percent interest rate, which is quite low, £100,000 invested now would rise to £200,000 in fifteen years. At a rate of just over 2.5 percent – and UK interest rates have not been that low since just after the Second World War – it would double over twenty-five years. Put another way, if you were asked what £200,000 spread over twenty-five years was worth to you now, the answer might be, depending on what you expect interest rates to do, a much smaller sum, perhaps £40,000 or £60,000. This is known in economics as the present value of a sum received in the future. The number you have used to come up with it is called the discount factor – how much you would be prepared to trade money upfront for a stream of income in the future. It is most commonly used in decisions about investment. In this case it tells us that to match the offer of £100,000 now, something rather more than £200,000 would have to be offered spread over twenty-five years.
I have digressed again, and time is moving on. The central point is that while the initial price of a house will be the main factor in the amount of a mortgage, the level of interest rates determines how much that mortgage costs. This is where analysis of the housing market gets quite interesting. Many amateur observers of the market, and quite a few professionals, have a blind spot when it comes to this. A fierce debate raged in Britain in 2001–2 about whether a housing ‘boom’ then under way was about to come to a sticky end, as its predecessor did in the early 1990s. A little nervousness was perhaps in order. Peaking in 1989, house prices fell by between 20 and 30 percent over the next four years, and by much more in some areas. Those who had bought near the top, and quite a few more, found themselves in ‘negative equity’ where the value of their property was less, by a considerable amount in some cases, than the mortgage they had taken out to buy it. This, the opposite of the equity enjoyed by most homeowners in their houses, affected more than a million households. A fall in house prices of this kind had not happened in Britain since the general deflation (a period of falling prices for everything) of the 1930s.
As in 1989, said the worriers of 2001, the ratio of house prices to incomes had begun to stretch higher. Surely this presaged an imminent collapse? The trouble with this was that it ignored the crucial factor of interest rates. In 1989 interest rates rose to 15 percent. In 2001 they dropped to 4 percent. The implication, in terms of monthly mortgage outlays, was huge – people could afford to borrow more while using a smaller proportion of their income in payments. They could afford to ‘gear’ themselves up. Indeed, much of what was happening to the housing market at the turn of the millennium and after could be seen as a gradual adjustment from the high interest rates of the 1970s and 1980s to the much lower rates that prevailed from around 1993 onwards. There may be an argument for a permanent upward adjustment in the normal ratio between house prices and incomes.
One puzzle observers from other countries sometimes have is that mortgage rates are such a hot political issue in Britain. Gordon Brown’s decision to give control of interest rates – independence – to the Bank of England in 1997 was partly to get away from the interview question that had dogged every Chancellor of the Exchequer: ‘Are interest rates going up or down?’ The reason it is a hot issue is that, traditionally, the vast majority of people with mortgages had variable-rate loans: every time the general level of interest rates changed, often monthly, so did their payments. This contrasted with other countries, where often the rate was fixed for the life of the mortgage. There has been a shift in recent years, with more new loans being on fixed rates of interest. But this has not rid the housing market of its interest-rate sensitivity. Apart from the fact that a large number of existing borrowers still have variable-rate mortgages, most fixed-rate loans are for relatively short periods, usually up to five years. And changes in short-term interest rates affect the rate on fixed-rate loans offered to new borrowers.
This is not to say other countries have not had housing market problems. Both Germany and Japan have had falling house prices since the early 1990s. In France, where flexibility of supply has tended to act as a dampener on house price rises, Britain’s periodic property booms are seen as a peculiarly Anglo-Saxon phenomenon. The general point still holds. Sharply rising interest rates will tend to be associated with a weakening of housing demand, and vice versa when rates are falling.
Intelligent observations
Sorry to have gone on so much about housing. It just shows that when you get into a conversation about these things it can be hard to stop. What it also shows is that a little bit of economics can take you a long way. No longer do you have to wonder uneasily whether the pub bore might be right when he tells you that house prices are going to fall for the next thirty years. Just ask him whether he thinks incomes are going to fall over that period, and why that should be. No longer, too, do you have to smile politely when somebody suggests that, irrespective of the level of interest rates, house prices are too high. You know better. And when you see one of those newspaper pieces asking whether houses or shares are the better investment, either read it with a superior smile on your face or just turn the page. This is what economics is about, replacing assertion with argument, anecdote with analysis. And as we shall see, it can be applied to very many things ‘in the ordinary business of life’.
Interest rates and incomes are vital to the housing market but we have not talked about what determines them. That will come soon. In economics, as most people know, the study of individual markets is known as ‘microeconomics’, while both interest rates and the growth of incomes are ‘macroeconomic’ variables – concerned with the overall economy. Micro is small, macro big. Housing is a bit unusual in that respect too. While economists would regard the market for potatoes or, say, the housing market in Milton Keynes, as the preserve of microeconomics, the housing market in aggregate is so important that it makes it into the macroeconomic arena. All will become clearer when we look at how economic policy works. Time, however, is moving on. A sip of wine, and then on to the main course.
Rude of me, I know, but I have not yet introduced you to the other guests at the table. Meet Mr and Mrs Rational – economic man and economic woman. They are not a bad couple, even if everything they do can be a bit predictable. I shall come on to them in a moment but let me just set out the aim of this main course. It is easy to get the idea that economics is about the billions of dollars flowing around the world’s financial markets, or about whether the Chancellor increases public spending or taxes by a billion pounds or two, but human behaviour is at the heart of it. The aim, then, is to start with the behaviour of economic man and woman and try to build up from that to a picture of how the economy as a whole works. If that sounds a bit daunting, let me assure you it will not be. We will just start at the bottom and work our way up. Time to tuck in.
Behaving economically
Many people have trouble with the idea that human behaviour is predictable. Surely, most will say, it is inherently unpredictable. Economic man or woman may be acceptable in the textbooks but do they really exist in real life? If you are like me there are plenty of times when you will have made a stupid purchase (one of the ‘lemons’ of the last chapter) or some other bad and apparently unfathomable economic decision. On a more mundane level, how can economics explain why I choose to buy a new shirt on a whim, or walk to work rather than catch the bus? An aerial view of Oxford Street would surely show us scurrying around haphazardly, like a colony of ants.
Apart from the fact that there is nothing haphazard about the way a colony of ants behaves, the essence of economics is that human behaviour follows predictable patterns. When the price of something falls, for example, we will tend to buy more. There is nothing difficult or surprising about that. Even so, it appears that many see it as pseudo-scientific mumbo jumbo. Denis Healey, Britain’s Chancellor of the Exchequer from 1974 to 1979, perhaps one of the most torrid periods for the economy in modern times, found plenty to criticize in the economic advice he was given. He declared his intention of doing for economic forecasters ‘what the Boston Strangler did for door-to-door salesmen – to make them distrusted for ever’. As for economics in general, he was far from convinced of its usefulness. He wrote in his autobiography,
The Time of My Life
: ‘I decided that while economic theory can give you valuable insights into what is happening, it can rarely offer clear prescriptions for government action, since economic behaviour can change from year to year and is different in one country from another.’
Healey was not being as damning as he thought. His central point that behaviour can change from one year to the next and differs between countries is not one that any economist would have any difficulty with. During the period he was in charge inflation rose to a peak of more than 26 percent, the stock market plunged by two-thirds in value, the world economy had to try to cope with a quadrupling of the price of oil and Britain, apparently on the brink of bankruptcy (although countries never actually go bankrupt) had to seek help from the International Monetary Fund. What was changing was not so much fundamental economic behaviour as the forces acting on that behaviour, which were outside previous experience. There is another point, and it is one we shall return to, which is that rational behaviour can mean behaving differently at different times in response to similar circumstances. If you have bought a dud timeshare holiday once, you probably would not do so again, even if faced with the same inducements. If the price of oil quadrupled again, you would want to take your money out of the stock market. This kind of learning process is part of rational economic behaviour.
What about that unpredictability point? How can anybody explain or predict why on a given day I decided, perhaps with this meal in mind, my wardrobe would not be complete without a purple and green striped shirt? What if everybody decided to buy one of those shirts on a particular day and then nobody decided to buy any shirts for a week? The answer is that, as long as there are enough of us, the unpredictable behaviour by some will cancel out. Even on an individual basis, we are not as unpredictable as you might think. An economist may not be able to predict the exact day you will buy that shirt, and he may not be able to explain your appalling taste in colours (although he could go a long way towards doing so). But he knows, given your income, you will buy a certain number of shirts over a period. That is why firms spend so much acquiring information on people’s spending patterns and bombarding us with marketing literature that taps into those patterns. If everybody behaved haphazardly there would be no point in doing so.
Carrots and sticks
In his excellent book
The Armchair Economist
, Steven Landsburg writes: ‘Most of economics can be summarised in four words: “People respond to incentives.” The rest is commentary.’ We have been here a little bit before, in the discussion in the last chapter on potatoes, and why they are different from houses. When potatoes fall in price we are likely to buy more of them and vice versa. Just to add to the confusion, incentives are popularly known as carrots and disincentives as sticks. Why do most of us keep working when there are much more pleasant things to do? Because the carrot of a gradually rising income bobs gently in front of our nose, while the stick of an alternative life of destitution brings up the rear.
The most obvious example of incentives is the one already described. When the price of something falls we will tend to buy more of it. There are exceptions to this rule but not many. A few years ago, when a price war broke out between newspapers in Britain, many economists thought that newspaper proprietors were effectively throwing money away because people did not buy papers on price. Because the cost of a paper represented such a low proportion of income, a little like the usual textbook example of a box of matches, demand was expected to be unresponsive to changes in price, or ‘inelastic’. In fact, it turned out to be quite elastic, demand for
The Times
increasing in response to price cuts, with the overall broadsheet market expanding when other newspapers followed suit. Economists are always looking for exceptions to the rule. In the nineteenth century Robert Giffen noticed that for certain basic commodities, such as bread and potatoes, demand appeared to go up when prices rose. In very special circumstances, it worked. Imagine a family on very low incomes with a diet of potatoes and meat. When the price of potatoes goes up – but is still well below that for meat – their response is to cut out some of the meat and replace it with a larger amount of potatoes. Higher prices mean more, not less, demand. There may have been a real-life example of this during the Irish potato famine. Giffen’s observation earned him a place in the economics equivalent of the Hall of Fame, with certain goods being known as Giffen goods. Economists have, however, found it hard to identify sustained examples of them. It is a curiosity rather than a rule.
So-called inferior goods can also break the normal rule. Tripe, cow’s stomach, used to be part of the regular meat diet of many people, particularly those on modest incomes, in the Midlands and North. As people’s incomes rose and the relative price of other meats fell, they were able to move on to chops, joints and even steaks. It did not matter that the price of tripe was falling, because demand also fell. These things, it should be said, can come full circle. Later, when French cuisine came to Britain in a big way, tripe became a delicacy much in demand at the best restaurants. It may even be on our menu today. Again, though, we should not get hung up about this. While it may have been true that over time the demand for tripe fell in spite of lower prices, on any given day during that process a butcher cutting his price could expect to sell more. You have to distinguish the short- and long-run effects.
Fish and chips
Paul Krugman, the American economist who is always worth reading, has a good example on his website of the effects of changing tastes and incomes. His short paper, ‘Supply, Demand and English Food’, tries to answer the question of why restaurant food in Britain, which ‘used to be deservedly famous for its awfulness – greasy fish and chips, gelatinous pork pies and dishwater coffee’, had suddenly got better. His conclusion was that industrialization and the shift of huge numbers of people from the country to towns and cities had made people in Britain forget about wholesome food and accept inferior, processed alternatives – canned vegetables and preserved meats – which were easier to ship and store. Prosperity rose but tastes did not change, mostly because people knew no better. According to Krugman, who is only half joking: ‘Because your typical Englishman circa, say, 1975, had never had a really good meal, he didn’t demand one.’ Only when people began to travel more widely, and began to experience other countries’ cuisines, did they demand better quality. ‘So what does all this have to do with economics?’ asks Krugman.
Well, the whole point of a market system is supposed to be that it serves consumers, providing us with what we want and thereby maximising our collective welfare. But the history of English food suggests that, even on so basic a matter as eating, a free market economy can get trapped for an extended period in a bad equilibrium in which good things are not demanded because they have never been supplied, and are not supplied because not enough people demand them.
Fun, and surely right.
Pricing to sell
Having wandered off down a little byway it is worth returning for a moment to the central point. Why do we buy more of something when its price falls? With the exception of Bill Gates and a fairly limited number of other very rich people, most of us are limited in what we can spend by our income; we are subject to a budget constraint. Within that constraint, we allocate our spending on the basis of necessity and desire – some on food, drink, travel, books, entertainment, and so on. I buy a certain number of CDs every year. I could buy more if I chose to eat a little less but I am happy with the way things are. I have made my choices. To economists, I am ‘indifferent’ between the number of CDs I buy and the number of meals I eat. Odd word, I know, but all it means is that, for a given level of income and pattern of prices, this combination of spending is right for me.
Now what would happen if the price of CDs were to halve? At the very least you might think that I would buy twice as many, because I could do so while devoting the same proportion of income to their purchase. I could, though, buy exactly the same number and use the money released to buy nicer meals, travel more or go to the cinema more often. I could even save more. If I did that, the cut in prices would have had no effect and our rule would have been broken. So what would one expect? Within my own pattern of spending, CDs have suddenly become cheap relative to everything else. The cost of other things, expressed in terms of CDs, has gone up. So my future desired pattern of spending will be for a higher proportion of CDs relative to other things. Economists call this the ‘substitution’ effect – shifting spending patterns in favour of things that have fallen in price or, in the opposite situation of a rise in prices, away from products that have gone up. We demonstrate the substitution effect every time we buy more of an item emblazoned with special offer signs at the supermarket.
There is also, however, another effect. The halving of the price of CDs has made me better off. Why? Before the price cut my income allowed me to buy food, housing, clothing, travel, and so on, plus about twenty CDs a year. Now that same income allows me all those things plus forty CDs. The fall in price is equivalent to an increase in my income. In that respect, it is like any other increase in income, so just as I would not spend all of a pay rise buying more CDs, neither will I in this case. This is known, unsurprisingly, as the ‘income effect’. What it means, for me at least, is that the most likely result of a halving of the price of CDs will be quite a big increase in purchases of them (but not a doubling) and smaller increases in my consumption of everything else. In the opposite situation of a rise in the price of CDs, assuming no change in my income, all of the above would be reversed.
A good real-world example of this goes back to the previous chapter. When interest rates fall, one of the prices (and the costs) of housing – the one that affects household budgets – has come down. The substitution effect of this is that you think of buying a bigger house, and some people do so. The income effect is that you have become better off, a fall in interest rates being equivalent to a rise in the borrower’s income. And, because you are better off, you spend more on items other than housing. That is one of the ways that monetary policy works, as we shall see later.
Getting satisfaction
Before moving on, time to tackle a little puzzle. What determines what we spend our money on? Why some things rather than others? Many people would answer ‘need’ to this question. Britain’s Office for National Statistics, which produces the annual Family Expenditure Survey, on the basis of a sample of more than 7,000 households, found that at the end of the 1990s, for the first time, people were spending more on leisure than food. In 1999–2000 the average household spent £360 a week, of which £62 was on leisure, £60 on food and non-alcoholic drink, £57 on housing (mortgage payments or rent), £53 on motoring, £31 on household goods, £21 on clothing, £19 on household services, £15 on alcohol, £14 on personal goods and services (such as hairdressing), £11 on fuel and power, £6 on tobacco, and so on. Earlier generations, of course, would not have had the luxury of devoting more than a sixth of their weekly spending to leisure, with feeding and housing the family taking up most, if not all, of their income. Prosperity has brought with it an increase in consumer choice. We can go to the opera (although a ticket at the Royal Opera House costs more than the average family’s weekly leisure spend), or get fat on the sofa watching televised football. The other thing that determines how we spend our money is taste, our personal tastes.