Elastic problem

Dan Davies argued recently that supply and demand are overrated in understanding the UK’s housing market, and that bad regulation may be a more apt culprit.

I’m not so sure: ignoring the supply side, as he largely does, means that he misses the reason the mechanics he blames can happen at all.

Mr Davies’ (a senior research advisor with Frontline Analysts) case is roughly this: houses are assets that people can invest in and earn a return on just like shares and bonds. Since the assured shorthold tenancy (AST) laws were changed in 1997 to allow eviction of tenants within two months, investment in rental properties has become viable (since tenants can be kicked out and the properties sold quickly), kicking off the buy to let boom. Buy to let properties are now a bit like investing in a pension, with the rents you earn being equivalent to the yield on government bonds or other dividend-paying assets.

If government yields fall, we would expect other yields to fall too, including the ‘yield’ from buy to let properties. Rents wouldn’t be affected, so relative to other assets rentable properties become high-yielding. More and more money will flow into buy to let housing until the risk-adjusted return on investment there is roughly the same as it is on other financial assets. Prices rise – if supply is fixed or inelastic.

Pushing prices

This final point is arguably the most important piece of the puzzle.

Consider a scenario where the AST laws that Mr Davies blames existed, and interest rates fell, but housing supply was relatively elastic. As investors’ money flowed into housing, the price of housing would rise. But as the price rose, so too would the profits made on building new houses, which would push prices back down again.

This is the story that Simon Wren-Lewis tells about the interaction between house prices and interest rates which, to my mind, is a more parsimonious version of roughly the same story Mr Davies tells. As Mr Wren-Lewis concludes, “…if housing supply was very elastic, permanently lower real interest rates need not lead to higher house prices in the long run. Instead, they could produce much lower rents, because a lot more houses get built.”

So when Mr Davies writes that “it is unlikely that any realistic housebuilding programme will have much effect on rents”, the word realisticis doing a lot of work – he is assuming away the possibility of a supply side response. He may be overly pessimistic: when the words green belt aren’t used, only 15% of people think land should be protected from development just because it’s close to a town or city.

Mr Davies’ preferred alternative is to try to make Britain more like Germany, where less than half of households own their own home. To make it less unpleasant to be a renter is no bad thing, but how could we do this?

German inspiration

Making long-term leases of five years or more the norm is not obviously a good idea: the AST rule changes were designed to address the shortage of rental market properties that emerged followed Right to Buy. Ditching AST in its current form could be counterproductive, risking a fall in the supply of rental properties. Good news for house prices, perhaps, but bad for renters on low incomes.

Germans’ relative preference for renting seems to be at least partially because rents are low and the quality of rental properties is quite high, a trend dating back to the post-war era where Britain focused on building council housing whereas Germany subsidised the private sector as well. Rent controls, sometimes cited as the big difference, are unlikely to be important – Britain has many more tenants on reduced rents than Germany.

But Germany does not have green belts, and since at least 1980 it has consistently built more houses per capita than the UK. More building may be one reason why Germany’s housing market looks healthy where ours does not. In any case, it is no less a fantasy to imagine that we can tell Britons to stop wanting to own their own home as it is to hope to persuade them that building more houses might be a good idea.

Along with interest rates changes, the pro-buy to let regulations that Mr Davies identifies are probably an important part of the story of British house prices too.

But they are only one blade of the scissors. Contra Mr Davies, supply and demand is a very, very important part of the story: it is only because supply is very inelastic that housing can be a financial asset.

Sam Bowman, deputy director, Adam Smith Institute