Chris Johns: Relax Paschal, stop trying to run a budget surplus

High house prices are a global phenomenon. The latest twitch in the property market always produces headlines: it was big news when it was revealed that Irish prices fell last year.

Housing costs are thought to be a driver of populism: one way people get “left behind” is when they can no longer afford the houses they grew up in.

Affordability, or its absence, is a political hot potato. Aside from driving voters into the arms of politicians like Boris Johnson and Donald Trump, it contributes to the homeless crisis afflicting cities like San Francisco, Dublin and London.

The political response is typically to declare that more houses need to be built – supply must be increased. What often happens next is a scheme that boosts demand: Help to Buy and similar wheezes that serve to increase prices further.

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Affordability is usually measured in terms of house prices relative to incomes. (See, for example, the regular reports on myhome.ie) Recent data suggest that affordability is roughly the same in both the Uk and the Republic.

The average house price in Ireland is 6.8 times average earnings, a level well above anything seen in the period 1975–95 but far below the peak of around 11 seen just before the great financial crisis. That multiple and ensuing crash were not unconnected.

The equivalent UK ratio isn’t that different: it costs seven times average earnings to buy an average UK house. While housing markets share many similarities there are local nuances: unlike the Republic the UK multiple is currently close to its all-time peak.

Housing policy

The narrative behind the “must build more houses” policy recommendation is intuitively plausible: more supply will drive down prices and those key ratios. However, if we are to get housing policy right it is important to understand why house prices went up in the first place.

And if the assumption is that prices have shot up because of a lack of supply we will, according to new research, be making a big mistake. That will, I think, come as a big surprise.

Economics can often be counter-intuitive. That, new research published by the Bank of England, suggests almost all of the rise in UK house prices in recent decades was caused by falling interest rates, not a property shortage. It is a stark conclusion with many implications.

Even if a lot more houses had been built, prices would still have been mostly driven by the fall in interest rates. This doesn’t necessarily mean that extra supply won’t reduce prices in the future. But don’t be surprised if more house building, even if delivered, has less impact on prices than you might expect.

The research is a careful study of long-term trends: it doesn’t explain the year- to-year gyrations in prices but establishes a strong connection between house prices and bond yields (the interest rates that really matter) over decades.

The authors note that rising property prices and falling bond yields have been global phenomena since the early 1980s: the connection may be a worldwide one, not just exclusive to the UK.

Interest rates

So what caused the fall in yields over the past 40 years?

Actually, according to another recent Bank of England study, interest rates have been falling for 800 years.

In a statistical tour-de-force, Paul Schmelzing looks at why governments everywhere can currently borrow at zero or negative cost. One conclusion is that we should have seen it coming: current levels of yields are merely the result of a visible trend that has been in place since the 14th century.

Bond yields don't attract the same attention as house prices. They should – they are much more important. For instance, if Schmelzing is right, the doyenne of inequality researchers, Thomas Piketty, is wrong. Not about the fact of inequality but about its causes: Piketty's thesis rests on stable, not falling, bond yields.

If Schmelzing is right, Larry Summers, promoter of the "secular stagnation" thesis, is also wrong. Anyone expecting bond yields to "normalise" is also wrong because their definition of normal is wrong.

The conventional definition of housing affordability is also probably wrong. It fails to account for interest costs which, because of that fall in bond yields, have also collapsed.

Similarly, the conventional measure of government indebtedness (debt/GDP) is also wrong: interest costs have fallen dramatically. If that lasts, sustainable debt/GDP ratios are a lot higher than previously thought. Paul Krugman has been making these points for a while now. Maybe Paschal Donohoe should chill out a little: running a budget surplus when you are being paid to borrow could be seen as a little odd.

Historic norms

If bond yields at current levels are sustained then high house prices won’t look so strange. Relative to historic norms, stock market prices, particularly those in the US, look as stretched as home valuations – they might not, in fact, be as likely to crash as many analysts seem to think. At least not until or unless bond yields shoot up again.

The research supporting these radical conclusions is explicitly about the long term. Asset prices, bonds, houses and equities are driven by all sorts of weird short-term factors, not least the ups and downs of the business cycle. This is not a “this time is different” argument. Rather, it could well be that the current situation is much more normal than is conventionally thought. The implications couldn’t be more profound.