The Future of Everything

August 8, 2008

UK House Price Crash?

Filed under: Uncategorized — David @ 9:59 am

UK house prices have now fallen by 11% in the year to July, according to Halifax. This is the first double-digit retreat since the Halifax index was started in 1984 (see this report in the Guardian). In recent months, prices have been falling at the annual rate of about 20%. When will they hit bottom?

Some believe that the severity of the recent falls means that prices will soon bounce back. An article in the Financial Times argued that pent-up demand means that “the market could change very quickly and this downturn could end up being short-lived compared with the five or six years of pain suffered last time.” Others such as housepricecrash.co.uk are calling for a fall of around 35%.

As with any asset, house prices don’t follow a completely regular cycle, but it’s still instructive to compare with history. The figure below shows how prices have expanded in recent decades in real terms (annual data from 1975 to 2007, prices rebased to 1975).

 

UK house prices, rebased

UK house prices, rebased

According to this it look like prices have a long way to fall. But it’s a little misleading, because most people buy with a mortgage, and interest rates are much lower than at the peak of the previous boom, so houses are more affordable. The next figure shows how estimated relative monthly costs look, after taking interest rates into account.

Estimated relative monthly payments

Estimated relative monthly payments

The plot is only approximate because it makes assumptions about how costs scale with mortgages, but it shows that what is remarkable about the recent boom was not so much its magnitude, but its duration – it took a long time to get to the top. A similar phenomenon was seen in other countries. The OECD Economic Outlook No. 78 notes that until the mid-1990s, many housing markets tended to follow a cycle, expanding in about six years and contracting in about five years, but this pattern broke when the global economy entered a regime of low interest rates and inflation.

One interpretation is that these factors set a kind of timescale for the economy. When inflation and interest rates are high, we learn to expect sudden price increases, and value also decays more rapidly, so economic time seems to be moving faster (an analogy in biology is the decay rate of proteins, which affects the size and rate of fluctuations in its level due to stochastic effects). That would explain why prices took so long to get to where they are, but it’s less clear how things will move on the way down, because the dynamics are different – more like a sudden release of tension than a slow build-up of force.

Whenever there’s a bubble in asset prices, a story is always developed that makes it look plausible – for example, house prices are high because the UK is an island without enough housing stock. But just because a place is crowded, doesn’t necessarily mean it’s expensive. Apart from its slow speed, the recent boom isn’t much different from previous booms, and the fall won’t be too different either. Real falls of at least 30% from the peak in the next few years don’t look at all unrealistic.

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