Effects of house crash on economy

Historically this has happened every 10 years or so and we are now overdue for the down-cycle. The house price - earnings ratio is the highest it has been since the war. Having said that interest rates are low and there is still demand for housing which have artificially maintained prices.

However I do feel it only takes a perturbation in the job market or price of oil, or increased / alternative taxation, to lead to a reduction in residual income and a subsequent fall in the confidence of house prices to precipitate a "crash". By it's nature house prices have a boom bust outlook.

In message , Fred writes

I'd be inclined to place less reliance on history now that treasury have entered the fray. It seems to have passed unnoticed that Katie Barker's proposals for planning reform, published on budget day -- a good day to bury bad news, didn't come from environment or home, but from treasury. Prescott was most miffed at this trespassing in his bailiwick but shafting ministers has always been treasury sport. The important thing to consider is that what treasury want, they get.

Of course its absurd that so many people are enslaved for a goodly chunk of their working lives paying for a commodity with a useful life span of around 150 years. The materials aren't that expensive either: sand -- the UK has plenty, also clay, gravel and gypsum. Timber -- the Forestry Commission (set up to ensure a supply of pit props) grow the stuff on trees. Land -- well, we've built on only 13 per cent in the south-east, the average for the rest of the country is only about 10 per cent. Fly into London Airport (Heathrow) and one is greeted by vast swathes of green just waiting for lots of little brick boxes.

The social climate is different today. In the 1970s people got married and lived together as family units under single roofs. This made for reasonably efficient use of homes. Today the fashion craze is for single parent families which makes inefficient use of the housing stock. Maybe treasury have got a point: we need to sweep away planning controls and encourage plenty of private enterprise house building.

But not in my back garden.

I heard somewhere on the TV or Radio last week that they reckon the average profit a builder now makes on a new 'average' build is 120K.

This would seem reasonable as 2 or 3 years back I talked with a builder whose company, then, was contracted out building homes for the well-known house-builder and he claimed that on a 60 or 70K house the cost of materials was about 8K plus, bearing in mind they built these things like Ford built cars, labour costs, per house, of not much more.

It's not the builder that makes the lion share of the profit, but the landowner. I do agree though in such a building boom they're doing very nicely.

There has been quite some inflation in building materials, law of supply and demand. I am also not convinced by your builder's claim.

Also remember there are also substantial taxes due after planning permission has been granted.

In message , John Smith writes

Housebuilders tend to work on a gross profit of around 15% to 20%, so on the typical house at £150,000, the profit is around £20K to £30K, and pro-rata. Nett profit will be less.

Clearly those that bought the land years ago will make higher profits, but holding the land will have had a cost.

I read some study that concluded the effect on the economy of a housing crash was twice as great as that of a stock market crash, i.e. s 20% drop in house values had the same effect as a 40% drop in stocks.

Well, we had a 50% drop in stocks last year with no immediate bad effects. We have to look to the last housing downturn around 1988-1994 for clues. We had a recession during that downturn, but the causal link is not always clear since we also had a period of high oil prices then due to Gulf War I, so which one was the greater conrtibutor to the economic downturn?

It is obvious that it will have some impact since the "wealth effect" will drop, labour mobility will slow down due to negative equity, jobs in the housing sector will go with its ripple effect, consumer spending from remortgaging will evaporate, people's retirement from house sales will be hit, etc.

All a bit complicated, but I see no reason why another 90s style recession is not on the cards. I would also note that the 90s housing downturn also had it global characteristics too.

Roland.

There's a little estate near here (Surrey-W Sussex border) called Durfold Wood [1] which has been relatively free of planning for about half a century. It consists of one acre plots which cannot be sub-divided. Instead of a ramshackle shanty town, which planners use as a justification for their existence and their absurd restrictions, it consists of swish, very upmarket properties -- everyone is different.

Maybe that's what we need: plenty of half hectare plots available for folk to plonk down their own homes starting with one-bedroom units and expanding as need and income rises. Planners allowing five or six units on a plot merely drives up the price of land.

There's one big difference. Most stocks are not bought on credit.

I think it's important to distinguish between which is cause, and which is effect. If house prices fall, then why should that really cause problems for the economy? It wont be so good for the house builders, of course.

If the economy were to falter, on the other hand, then that's a different kettle of fish. I would be very suprised if house prices didn't fall as a consequence.

Also, as a previous poster pointed out, if house prices fell by 30% (or was it 40%), then they'd still be at 2002 levels. I'm sure this news would be plastered all over the gogglebox, and the Money Programme will tell us all the doom and gloom relating to housing, and what's going to happen to the economy. But would you necessarily expect that this implied that the economy was about to collapse?

That begs the question of what could cause the economy to falter. One opinion touted a lot is that a lot of the consumer-led recovery is based on remortgaging. A drop in house prices would surely curtail that severely.

Roland.

There are still very few people saying that this isn't a housing bubble but a credit bubble.

Naturally I still expect that to change. The latest danger of it puncturing looks to be a rise in Chinese interest rates. The two hikes in bank reserve requirements don't seem to have punctures the credit and property bubbles there.

FoFP

The drop in house prices will be a symptom, not a primary cause. As you say though, there's likely to be feedback effects once things get going.

FoFP

OK, call me stupid but why would a rise in Chinese interest rates affect us here in the UK - especially the housing market?

Surely credit and housing bubbles are one and the same whether people are borrowing money en masse for houses or for cars, hoildays, whatever. It is still credit if you have a mortgage after all.

John.

Best check experts like Roach and Nye on this but the basic scenario is:

1. There's a global credit bubble.
2. This is mainly fed by very loose monetary policy at the US federal reserve as they pump money to offset deflationary trends in the US economy and prevent the economy working off the excesses set by the dotcom bubble. (It's utterly uncontroversial that Greenspan and Bernanke believe that ultra liquidity is the solution to deflation and pretty much anything else that ails ya, just read some of the Fed papers out in the past couple of years, or look at Greenspan's actual responses to previous crises).
3. The US has so far paid no penalty for this because the Chinese and Japanese have been buying the Treasuries (and Fannie and Freddie mortgage-backs) from the Fed in order to manipulate their own currencies against the trend downwards of the Dollar. Though the Japanese reputedly quit this recently.

The end result is that effectively, the credit bubble, and the world economy that runs on it, amounts to the Chinese loaning the yanks money to buy Chinese exports. The symptoms are record US trade and fiscal deficits as they swap IOU's for goods and continue to live well beyond their means. Added to this are US refis which have cut US home quity from 75% to 55% despite a doubling in house prices over the past decade.

1. One result of this is that the bubble has extended to China, with one symptom there being a speculative boom in property.
2. The Chinese authorities, being fearful of a crash and return to deflation (with the attendant risks of political trouble accompanying it

- these are guys who know they need to produce 8% per annum growth or end up with their heads on a pike) have tried to rein in the bubble. So far they've tried direct threats to banks, then two increases in reserve requirements. In conventional terms all that's left is interest rate hikes.

1. If the Chinese effectively spike their bubble, the US will most likely have to raise interest rates to keep folks buying Treasuries (or cut government spending by about a quarter). That will gut the US bond markets and the fun that Freddie and Fannie have been having with mortgage-backs. Since that's the epicentre of the global credit bubble, when that market goes, the bubble goes. End of low interest rates and cheap finance and most likely the appearance of the deflation that it's offset, and then some because the credit bubble was blown much larger over the intervening years.

I agree that in the anglo-saxon countries at least, the credit bubble has largely been based around mortgage credit with freely available credit both pumping up house prices and producing the asset against which to gain more credit.

See:

The short form is: This time it ISN'T different!

FoFP

All the "usual suspects", I suppose; and maybe some of the unusual ones.

A rise in unemployment would do it - maybe due to continued erosion of manufacturing competitiveness, for example.

And a substantial rise in interest rates - I think that'd really clobber the economy. I think that many people are juiced up to the yin-yang in debt. So if things turn bad, they could turn very bad.

Maybe other people can think of other reasons.

It is my opinion that the BoE has been irresponsible for keeping interest rates so low for so long. The theory seems to have been that consumers will load up on debt and keep them spending, and the economy going. I honestly think that this has been a very bad idea.

Yes, that's basically my contention. It's not impossible to imagine a state in which things actually tick along, but house prices still decline (rather than crash), though. After all, house prices stabilisation isn't out of the question.

Of course, we'll all actually have to wait and see to determine how events transpire. I don't think it is ever really possible to predict exactly how events will pan out. There's always something one didn't think of; or perhaps one can overweight criteria that one later finds out were of lesser significance.

Yes, it's truly amazing, isn't it. I recall Lamont saying that he thought that government interference didn't help. And, I seem to recall that Healy said largely the same thing, too. Some commentators even suggest that government intervention is actually a significant cause of the problems.

And this is all common knowledge. There's nothing new to the idea that "monetary policies don't work". Yet, time and time and time again we see officials ignoring these basic conclusions. Why do they do it?? It completely beggars rational explanation. Do they know nothing about what it is they are doing?

Unfortunately, it's the poor twirps at the bottom like us who will have to pay for all this foolishness at the end of the day.

Sigh. The more things change, the more they remain the same.

I think this is partly the "fighting the last war" syndrome. The last war has been The Great Inflation, more or less since shortly after the end of WWII. Since inflation is what we were used to fighting (though not very effectively since politicians use it to purloin money for the welfare state) the BoE was given the job of targetting "price stability", which meant "a little inflation" rather than an inflation rate of zero.

This doesn't work in the deflationary part of the credit cycle because it means that the Bank needs to run a loose monetary policy just at the point when inflation is very low, in order to prevent deflation. Significantly because of the US experience in the 1930's, as well as more recent Japanese experience, deflation is also fought because it's blamed as being a cause, rather than a symptom and a cure of, economic problems which follow a bubble.

So what we get is low interest rates, which then encourage people to borrow and chase assets, which inevitably inflate due to the amount of credit chasing them (which particular assets doesn't much matter since they can be arbitrarily chosen to be anything from houses through stocks to tulip bulbs). As the bubble matures, more credit becomes available through people borrowing against inflated assets.

The problem is that one bubble already broke, and since the deflation which the authorities saw coming after this has been misidentified as a problem rather than the cure, they're willing to accept other bubbles if they keep the credit pump going and demand up. Of course this only increases the size of the credit bubble to be punctured, and inevitably the amount of resource reallocation to follow, but for any given person in charge, it's better to hope that either something turnsup, or the bust happens after their watch, than to accept the bust while they're in charge.

They can always claim as Greenspan has, that a bubble can only be recognised after it bursts.

I've read rather a lot about bubbles, and this hope is rather common. However the very mechanism of a bubble runs against this. If it stabilises, then the source of more credit vanishes. Then the demand that upheld it vanishes with it and deflationary dynamics take hold again. Bubbles must grow to keep going, and since each 1 percent of growth will inevitably involve more money than the last percent, eventually they overtake the ability for the credit to be serviced, if panic by either borrowers or lenders doesn't hit in the meantime.

An example of how this works would be a buy-to-lettor. Let's say he pays out 4% per annum capital cost plus 3% per annum amortised interest interest. Add in 3% percent amortised transfer/insurance/repair costs and if he can get rent of over 10% then he's laughing because even his capital repayments are covered. If he can get rent of over 6% then he's doing alright. If less than this, then he's losing money on cashflow.

However during a bubble, that'll be more than covered by price rises in the asset. In many places just now, landlords could afford to leave houses empty and still make an annual profit.

If prices stabilise though, the math reverses. Now they must make 6% of capital value or they're losing money. Even then, they have to make the capital payments out of other cashflow or savings, which won't be possible for folks who are too highly leveraged. At this point some are headed to become forced sellers (if they can afford to bribe their tenants to quit). However, while up markets are very liquid, down markets are not. Landlords will be hit by this at the same point, and will be in competition with each other to sell. There'll also be a dearth of folks trying to get into the BTL market as news hits the comics. The most and least desperate will cut prices for a quick sale.

This of course means falling prices. At this point the math really starts to run against the highly leveraged. Even those making a sufficient rent (and with falling prices comes falling rents) will see it offset by capital falls. This produces a need for more people to get out and the race for the bottom that Chancellor called "Devil Take the Hindmost".

Meanwhile the dynamics work in a similar way, if more slowly, for simple owners. Falling values mean not only that credit can't be had against the assets, leading to demand shortfall in the economy, but also to nervous creditors looking for sonme insurance on those 100% or even 120% loans they've been making at silly multiples. At first any buyers such as there are see a requirement of 20% deposits and higher rates and credit standing, eliminating demand. Later the squeeze goes to folks who fall behind with payments, or just give up as they see negative equity. Folks go bankrupt and the houses flood the markets for a quick sale, depressing prices.

Demand shortfall in low inflation leads to deflation and falling prices generally. Now loans must be paid back with money that becomes more valuable each year. Folks try to pay down capital to reduce their outgoings, particularly as there's pressure on wages to drop in line with deflation in order to avoid redundancies. That debt payback, and debt defaults, reduce the money supply and lead to more deflation. Asset values are hardest hit as eventually credit is neither sought nor offered, and prices head for the market-clearing price for cash trades.

That's the short summary of a burst credit bubble. Read it for yourself with tulip bulbs in Amsterdam; South Sea Shares in Britain or Wall Street Stocks in the US. The credit always works the same way and there are very similar phases to each cycle. All you have to do is substitute the name of the new Magic Money Token.

Me neither, which is why I still won't predict the peak. We have seen pretty much all of the usual up phases though. The final phase often involves the uncovering of substantial frauds in the primary markets. It's interesting that both Freddie Mac and Fannie Mae have been caught in multi-billion financial misstatements in the US. The next marker would be something similar here.

That aside, the fact that it's impossible to arrive home from work and switch on the TV without hitting a property show is pretty much the "stock tip from the shoe boy" marker that ought to be tipping off the smart money.

Probably. Was it Mark Twain who said that history doesn't repeat, but it does rhyme?

I'll leave you with an economics joke I just heard (reputedly told during the Wall Street Crash):

During 1929 a man repeatedly calls his broker to buy a particular stock that's booming. In early October, he's smart enough to see the signs and having amassed a fortune, decides to sell. He phones his broker and gives him the order. His broker asks "Who am I going to sell to? YOU'RE the buyer."

FoFP

As the resident Libertarian, you can't expect me to disagree with that. More specifically, government funny money is the major part of the problem.

Government is a fairground game where 12 people buy 10 Pounds tickets and the lucky winner gets a 60 Pounds prize. Everyone hopes that next time they'll be the winner and the huckster remains popular.

Inflation is one means whereby they shill the marks. Unfortunately, where there's inflation, there's a credit cycle. Given that the guy in charge when it turns to a bubble and burts is going to lose his position as Huckster In Chief and the goodies that go with it, they'll keep the game going using any means necessary, even if it means the bust will be bigger, simply because it also means it will be later.

They know some but not as much as they pretend. They're rationally following self-interest, just as are all the folks who are borrowing to invest in big profits.

See: the politicians take part of the gains and can largely foist the losses onto someone else. What could be more rational than to play a game like that to the hilt?

FoFP

Thanks for the full reply.

Isn't that a bit like claiming that you can only know how dangerously someone is driving by the number of people that get mowed down? ;)

Yes - when this time it's a "permanently high plateau", it's time to head for the hills. Let's not hope we're not heading for Great Depression The Next Generation.

I was interested in your remark about technology. It's interesting to note that despite the acceleration of technology, we've still experienced inflation. Technology is inherently deflationary - because it allows for greater production and/or at reduced cost.

But technology-driven deflation need not necessarily be considered harmful. Look at Intel, for example. The price of chips has tumbled down over the decades, yet Intel's profits have been generally increasing.

Perhaps we should be worried about deflation which is not technology-led; which arises as the result of the misallocation of capital.