Housing, consumption, and the economy: Why do house prices become misaligned, and what are the consequences? Andrew Farlow University of Oxford Department.

Housing, consumption, and the economy: Why do house prices become misaligned, and what are the consequences? Andrew Farlow University of Oxford Department of Economics, and Oriel College Guest Lecture (with expanded post-lecture notes) The London Business School 2 June 2005 This lecture is based on papers to be found at: www.economics.ox.ac.uk/members/andrew.farlow

Today’s presentation draws off a five-part project Part One: “UK House Prices: A Critical Assessment” Part One: “UK House Prices: A Critical Assessment” Part Two: “Bubbles and Buyers” Part Two: “Bubbles and Buyers” Part Three: “UK House Prices, Consumption and GDP in a Global Context” Part Three: “UK House Prices, Consumption and GDP in a Global Context” Part Four: “Risk Premia and House Prices” Part Four: “Risk Premia and House Prices” Part Five: “Mortgage Banks and House Prices” forthcoming Part Five: “Mortgage Banks and House Prices” forthcoming Book: Spring/Summer 2006, Publisher: Constable Robinson Book: Spring/Summer 2006, Publisher: Constable Robinson

Real house prices against trend

House prices against gross earnings

House price inflation Source: Halifax UK Real House Price Growth (annualized)

UK historically strong housing cycles Strong housing market cycles, linked to volatile consumption, have been an overriding feature of the UK economy for over three decades. Strong housing market cycles, linked to volatile consumption, have been an overriding feature of the UK economy for over three decades. OECD (2004): 1971-2002, UK the strongest correlation of housing wealth and GDP of any country surveyed. OECD (2004): 1971-2002, UK the strongest correlation of housing wealth and GDP of any country surveyed. IMF(2004): The UK (along with Finland, Ireland, and Switzerland) has had one of the most procyclical housing markets in the world. IMF(2004): The UK (along with Finland, Ireland, and Switzerland) has had one of the most procyclical housing markets in the world.

Something more global this time? Something extra this time: The “first global house price bubble” (The Economist)? Something extra this time: The “first global house price bubble” (The Economist)? BUBBLE: “a situation in which temporarily high prices are sustained largely by investors’ enthusiasm rather than by consistent estimation of real value.” BUBBLE: “a situation in which temporarily high prices are sustained largely by investors’ enthusiasm rather than by consistent estimation of real value.” Shiller, R.J., ‘Irrational Exuberance’ 2000 page xi Small-probability large-loss events – they matter. Small-probability large-loss events – they matter. Even if only a small chance, we should analyze the possibility. Even if only a small chance, we should analyze the possibility. IMF, 2003 World Economic Outlook, 40% of booms followed by busts, and 8% cumulative GDP loss (though important caveats about the data). IMF, 2003 World Economic Outlook, 40% of booms followed by busts, and 8% cumulative GDP loss (though important caveats about the data). State of housing markets, part of a bigger picture of global imbalances? State of housing markets, part of a bigger picture of global imbalances?

UK House price falls and GDP falls No fall in real house prices (blue line) not followed by major fall in UK GDP (gray bands). Will the pattern repeat? Source: Bank of England Inflation Report, May 2004, p7, Chart 1.10.

Market efficiency ‘Efficient markets’ view of asset prices: ‘Efficient markets’ view of asset prices: Financial prices always reflect all information (defined at various levels of stricture) – current price is an unbiased predictor of the future value of the asset if information arrives randomly. Financial prices always reflect all information (defined at various levels of stricture) – current price is an unbiased predictor of the future value of the asset if information arrives randomly. Explaining the way economists cling to ‘efficient markets’ thinking: Explaining the way economists cling to ‘efficient markets’ thinking: “A peculiar psychological disorder known as ‘physics envy'...We would love to have three laws that explain 99% of economic behaviour; instead, we have about 99 laws that explain maybe 3% of economic behaviour. Nevertheless, we like to talk as if we are dealing with physical phenomena.” Andrew Lo, MIT, financial economist Andrew Lo, MIT, financial economist

Market efficiency Following Fama, E.F., (1970), discrete case. Following Fama, E.F., (1970), discrete case. Let the expected return on an asset between t and t+1 be: r = E t [r t+1 ] = E t [P t+1 -P t + d t+1 )/P t ] Let the expected return on an asset between t and t+1 be: r = E t [r t+1 ] = E t [P t+1 -P t + d t+1 )/P t ] where E is the expectations operator where E is the expectations operator P is the per unit price of the asset P is the per unit price of the asset d is the dividend or rent d is the dividend or rent If E t [r t+1 ]-ρ = 0 is a fair game* where ρ is a constant term, then, by substitution, P t = E t [(P t+1 +d t+1 )]/(1+ρ) If E t [r t+1 ]-ρ = 0 is a fair game* where ρ is a constant term, then, by substitution, P t = E t [(P t+1 +d t+1 )]/(1+ρ) * Stochastic process x t is considered a fair game if E t [x t+1 ]=0. In the case here, E t [x t+1 ]=E t [r t+1 ]-r t. * Stochastic process x t is considered a fair game if E t [x t+1 ]=0. In the case here, E t [x t+1 ]=E t [r t+1 ]-r t.

Market efficiency Solving for n periods recursively, using iterative expectations (something that economists easily slip in without thinking too much what it actually implies about those, such as house buyers, supposedly doing it): Solving for n periods recursively, using iterative expectations (something that economists easily slip in without thinking too much what it actually implies about those, such as house buyers, supposedly doing it): If the second term converges to zero for large enough n, then the equation gives the long-run equilibrium price, and the value of the asset is the sum of expected future dividends or rents. If the second term converges to zero for large enough n, then the equation gives the long-run equilibrium price, and the value of the asset is the sum of expected future dividends or rents. If the second term does not converge to zero, then the asset price is said to include a ‘bubble’ term. If the second term does not converge to zero, then the asset price is said to include a ‘bubble’ term.

‘Efficient Markets Hypothesis’: Assumptions about investors 1) Either all investors are rational and this is ‘common knowledge’* or… 1) Either all investors are rational and this is ‘common knowledge’* or… 2) To the extent that some are not rational, their trades are random and cancel each other out so as not to affect price, or… 2) To the extent that some are not rational, their trades are random and cancel each other out so as not to affect price, or… 3) To the extent that some are not fully rational and their trades are not random but are serially correlated, rational arbitrageurs eliminate their influence on price. Market forces work to eliminate the wealth of the irrational types, and they die out in the population. 3) To the extent that some are not fully rational and their trades are not random but are serially correlated, rational arbitrageurs eliminate their influence on price. Market forces work to eliminate the wealth of the irrational types, and they die out in the population. * Several recent interesting models of bubbles have all agents rational, but that this not common knowledge, with the rest of the framework essentially classical. See Abreu, D. and Brunnermeier, M. K. 2003. * Several recent interesting models of bubbles have all agents rational, but that this not common knowledge, with the rest of the framework essentially classical. See Abreu, D. and Brunnermeier, M. K. 2003.

Market efficiency Sharpe et al.* defines a perfectly efficient market as “one in which every security’s price equals its investment value at all times”. Sharpe et al.* defines a perfectly efficient market as “one in which every security’s price equals its investment value at all times”. * Sharpe, W.F., G.L. Alexander and J.V. Bailey, 1995 Strongly ‘efficient’ market: Strongly ‘efficient’ market: Asset price changes should be unpredictable since they only respond to new information – which by definition is itself unpredictable. Asset price changes should be unpredictable since they only respond to new information – which by definition is itself unpredictable. Prices changes should follow a ‘random walk’. Prices changes should follow a ‘random walk’. Returns unforecastability – where the mathematical expectation of returns is based on all publicly available information at time t. Returns unforecastability – where the mathematical expectation of returns is based on all publicly available information at time t. Efficiency tests essentially become tests of forecastability of price changes. Efficiency tests essentially become tests of forecastability of price changes.

Problems testing efficient markets Power of statistical tests in distinguishing efficient markets hypothesis from alternatives is weak. Power of statistical tests in distinguishing efficient markets hypothesis from alternatives is weak. Null hypothesis of market efficiency not well defined. Null hypothesis of market efficiency not well defined. This is the ‘joint hypothesis’ problem: Market efficiency is always tested jointly with some model of equilibrium – i.e. some asset pricing model. This is the ‘joint hypothesis’ problem: Market efficiency is always tested jointly with some model of equilibrium – i.e. some asset pricing model. Whatever the result, it can always be claimed that the asset pricing model was misspecified. Whatever the result, it can always be claimed that the asset pricing model was misspecified. In particular, it can always be argued that a higher return could simply be compensation for accepting higher risk. In particular, it can always be argued that a higher return could simply be compensation for accepting higher risk.

Tulipmania To give some idea of how this problem bites: In testing the theory of 17 th century tulipmania, Peter Garber concludes that we cannot clearly declare it a case of ‘irrational’ pricing; gyrations in price could have been based on information revelations at the time about which we know relatively little now, and we may misuse our benefit of hindsight. Garber concludes however that he is “hard pressed to find any market fundamentals explanation” (Garber, P. M., 2000, quoted from Garber, P.M., 1989). As John H. Cochrane puts it (in a review of “Famous First Bubbles”): “Garber suggests fundamental explanations, but he does not nail the case shut. If it were easy, the events would not have passed into legend.” To give some idea of how this problem bites: In testing the theory of 17 th century tulipmania, Peter Garber concludes that we cannot clearly declare it a case of ‘irrational’ pricing; gyrations in price could have been based on information revelations at the time about which we know relatively little now, and we may misuse our benefit of hindsight. Garber concludes however that he is “hard pressed to find any market fundamentals explanation” (Garber, P. M., 2000, quoted from Garber, P.M., 1989). As John H. Cochrane puts it (in a review of “Famous First Bubbles”): “Garber suggests fundamental explanations, but he does not nail the case shut. If it were easy, the events would not have passed into legend.”

More on problems testing efficiency Furthermore, all models of asset pricing used in tests require current expectations concerning future paths of all variables in the pricing formula – no mean feat. Furthermore, all models of asset pricing used in tests require current expectations concerning future paths of all variables in the pricing formula – no mean feat. And no model is any good at dealing with non-linear feedback loops (even chaos) since this makes the tests – based on linear models – impossible to use to prove lack of a bubble (never mind the fact that agents are supposed to form expectations over the future paths of such systems). And no model is any good at dealing with non-linear feedback loops (even chaos) since this makes the tests – based on linear models – impossible to use to prove lack of a bubble (never mind the fact that agents are supposed to form expectations over the future paths of such systems). We never get definitive answers. We never get definitive answers.

Efficient house prices? If housing markets were efficient, housing prices would anticipate optimally the stream of real returns – including housing services – that housing will pay in the future. If housing markets were efficient, housing prices would anticipate optimally the stream of real returns – including housing services – that housing will pay in the future. Inefficiency = serial correlation of house price changes. Inefficiency = serial correlation of house price changes. Or, another way to think of this, inefficiency = future house price movements can be predicted from information available now, namely deviations from the long-run trend and recent price increases. Or, another way to think of this, inefficiency = future house price movements can be predicted from information available now, namely deviations from the long-run trend and recent price increases. The general conclusion is that housing markets are not efficient. The general conclusion is that housing markets are not efficient.

Specific Problems in Testing Housing Market Efficiency 1 Similar problems to testing for equity price bubbles – but probably much worse. Similar problems to testing for equity price bubbles – but probably much worse. We do not have many long or high-quality time series on prices or rents (the ‘dividends’ for real estate) for owner-occupied dwellings: We do not have many long or high-quality time series on prices or rents (the ‘dividends’ for real estate) for owner-occupied dwellings: The implicit rent of owner occupiers is never directly observed – there is no market to derive an exact valuation. The implicit rent of owner occupiers is never directly observed – there is no market to derive an exact valuation. We end up using proxies from rental indexes in government statistics. We end up using proxies from rental indexes in government statistics. But, if the measure is based on properties different from those that are owner-occupied – which it often is – the tests are biased. But, if the measure is based on properties different from those that are owner-occupied – which it often is – the tests are biased.

Specific house test problems 2 House price series are hard to construct: House price series are hard to construct: Real estate is not a standard commodity (size, quality, depreciation, expenditure on improvements, etc.). Real estate is not a standard commodity (size, quality, depreciation, expenditure on improvements, etc.). We would like repeat sales on the same properties where the kind and quality is known. We would like repeat sales on the same properties where the kind and quality is known. It is after-tax returns we want to know about: It is after-tax returns we want to know about: But agents vary in tax liability. But agents vary in tax liability. So, after-tax returns are pretty impossible to measure. So, after-tax returns are pretty impossible to measure. We need decades of data for analysis of volatility. We need decades of data for analysis of volatility. CONSOLATION: While there may be little chance of proving definitively that a market is not efficient, this conclusion may not apply in periods of extraordinary price rises… CONSOLATION: While there may be little chance of proving definitively that a market is not efficient, this conclusion may not apply in periods of extraordinary price rises… And these are usually the periods we are most worried about. And these are usually the periods we are most worried about.

Efficient Market OBSERVE: The the same problems that economists have, will equally apply to ordinary investors. OBSERVE: The the same problems that economists have, will equally apply to ordinary investors. YET we presume that these investors think about these issues in order to work out when and how to invest efficiently… including in housing! YET we presume that these investors think about these issues in order to work out when and how to invest efficiently… including in housing! CONCLUSION – It is a bit of a red-herring presuming that we can rely on tests of housing market efficiency for definitive answers. CONCLUSION – It is a bit of a red-herring presuming that we can rely on tests of housing market efficiency for definitive answers. Like a good doctor dealing with a difficult patient, we might want to treat tests as one of our possible diagnostic tools, and look at other analysis and at the logical reasons for why markets may find it hard to be efficient… for example, due to arbitrage failure. Like a good doctor dealing with a difficult patient, we might want to treat tests as one of our possible diagnostic tools, and look at other analysis and at the logical reasons for why markets may find it hard to be efficient… for example, due to arbitrage failure.

The bottom line “The bottom line...is that theory by itself does not inevitably lead a researcher to a presumption of market efficiency. At the very least, theory leaves a researcher with an open mine on the crucial issues....market efficiency only emerges as an extreme special case, unlikely to hold under plausible assumptions.” Schleifer, A., 2000, p16.

Simple test of housing efficiency Treat housing as just another other asset (something that ultimately gives utility via consumption, including housing services) and compare the change in the theoretical price of housing with the actual price. The theoretical optimal price (P*) equals the sum of the discounted future income that it will generate. Here, R is the rent level, g the expected growth rate of rents, r the mortgage interest rate, τ the risk premium. Those who own are treated as renting from themselves – which is how their ownership is treated in the National Accounts (Blue Book) under ‘imputed rent’* Treat housing as just another other asset (something that ultimately gives utility via consumption, including housing services) and compare the change in the theoretical price of housing with the actual price. The theoretical optimal price (P*) equals the sum of the discounted future income that it will generate. Here, R is the rent level, g the expected growth rate of rents, r the mortgage interest rate, τ the risk premium. Those who own are treated as renting from themselves – which is how their ownership is treated in the National Accounts (Blue Book) under ‘imputed rent’* * Or, since the alternative to owning is renting, the opportunity cost of owning (via payment of interest) is compared to the alternative of renting. So if the typical rent is falling as house prices are rising, then buying housing and renting it to yourself is getting more expensive than letting someone else buy it and you rent it from them. There are, however, some weighty problems in dealing with the tax advantage of housing and the different tax treatments of renting.

Housing market efficiency test Hence Hence If P/P* falls, real estate prices fall below their initial point (not necessarily the optimal reference point itself). If P/P* rises significantly (exceeding 1 with caveats) this is described as a ‘bubble’. If P/P* falls, real estate prices fall below their initial point (not necessarily the optimal reference point itself). If P/P* rises significantly (exceeding 1 with caveats) this is described as a ‘bubble’. To use this to work out the degree of overvaluation of a property market we need to know some moment at which the market was actually in equilibrium. To use this to work out the degree of overvaluation of a property market we need to know some moment at which the market was actually in equilibrium.

Bubble builder-bubble burster 1 Another popular (empirically-based) method used for checking for mispricing/‘bubbles’ in property markets, and applied in various countries, is the methodology of Abraham and Hendershott 1996. Another popular (empirically-based) method used for checking for mispricing/‘bubbles’ in property markets, and applied in various countries, is the methodology of Abraham and Hendershott 1996. Methodology is also useful for locating the moment at which a property market is in ‘fundamentals equilibrium’. Methodology is also useful for locating the moment at which a property market is in ‘fundamentals equilibrium’. (The nomenclature here is identical to that of Abraham and Hendershott) *Abraham, J.M., and P.H. Henderschott, 1996. *Abraham, J.M., and P.H. Henderschott, 1996. As an alternative, Hall, R.E., 1978, runs a stochastic switching regime model in real house prices. Booms in house prices are associated with an unstable regime. The probability of the system staying in the regime fall as deviation from equilibrium increases. As an alternative, Hall, R.E., 1978, runs a stochastic switching regime model in real house prices. Booms in house prices are associated with an unstable regime. The probability of the system staying in the regime fall as deviation from equilibrium increases.

Bubble builder-bubble burster 2 The equation for property prices contains a fundamentals long- run equilibrium term (based on the efficient markets hypothesis, using a standard asset pricing model), drppi t *, and an error term: The equation for property prices contains a fundamentals long- run equilibrium term (based on the efficient markets hypothesis, using a standard asset pricing model), drppi t *, and an error term: drppi t =drppi t *+u t drppi t =drppi t *+u t Concentrating on the fundamentals term for a moment. The growth rate of the fundamentals term is modelled as a function of the growth rate of rental prices, real interest rate, real construction costs and real effective exchange rate, real GDP, real GDP per capita, nominal wage, real wage, population, and various supply factors (with all prices, rent, etc. deflated by the CPI). All variables (except interest rates) are in logs, so that rppi = log real property price index, RINT = real interest rate: Concentrating on the fundamentals term for a moment. The growth rate of the fundamentals term is modelled as a function of the growth rate of rental prices, real interest rate, real construction costs and real effective exchange rate, real GDP, real GDP per capita, nominal wage, real wage, population, and various supply factors (with all prices, rent, etc. deflated by the CPI). All variables (except interest rates) are in logs, so that rppi = log real property price index, RINT = real interest rate: drppi t *=a 0 +a 1 RINT t +a 2 drrisa t +a 3 dpcrcgdp t +...+lagged variables drppi t *=a 0 +a 1 RINT t +a 2 drrisa t +a 3 dpcrcgdp t +...+lagged variables

Bubble builder-bubble burster 3 The error term is further specified to capture the dynamic adjustment. The term is the sum of a bubble ‘builder’ (expected future appreciation), a bubble ‘burster’ (the possibility of a price drop if price exceeds the fundamental price by a certain limit) and a random variable: The error term is further specified to capture the dynamic adjustment. The term is the sum of a bubble ‘builder’ (expected future appreciation), a bubble ‘burster’ (the possibility of a price drop if price exceeds the fundamental price by a certain limit) and a random variable: u t = λ 0 +λ 1 drppi t-1 +λ 2 (rppi t-1 *-rppi t-1 )+ε t u t = λ 0 +λ 1 drppi t-1 +λ 2 (rppi t-1 *-rppi t-1 )+ε t

Bubble builder-bubble burster 4 This analysis of course requires some estimate of the parameter rppi*, which needs also to be consistent with drppi* and the estimates of parameters a i. This is done as follows (and is worth explaining since it indicates a method for working back to the moment when the UK property market was last in fundamentals equilibrium): This analysis of course requires some estimate of the parameter rppi*, which needs also to be consistent with drppi* and the estimates of parameters a i. This is done as follows (and is worth explaining since it indicates a method for working back to the moment when the UK property market was last in fundamentals equilibrium): i) Estimate without λ 2 (i.e.. ignore λ 2 for now) i) Estimate without λ 2 (i.e.. ignore λ 2 for now) ii) Construct a first-pass estimate of rppi* by cumulating the drppi* over time using the parameter estimates derived from i); ii) Construct a first-pass estimate of rppi* by cumulating the drppi* over time using the parameter estimates derived from i);

Bubble builder-bubble burster 5 iii) Calibrate (not always a sound idea) the rppi* series on the assumption that actual property prices were, at some particular point in time, in equilibrium; iii) Calibrate (not always a sound idea) the rppi* series on the assumption that actual property prices were, at some particular point in time, in equilibrium; iv) Re-estimate drppi, this time including the λ 2 ; iv) Re-estimate drppi, this time including the λ 2 ; v) Keep repeating steps i) to iv) until the a i estimates stabilise, at which point the drppi* and rppi* will also have stabilised. This also pins down the year when the market was approximately in fundamental equilibrium. In the UK this would be about 1994. In the original paper, in Hong Kong it was about 1990. v) Keep repeating steps i) to iv) until the a i estimates stabilise, at which point the drppi* and rppi* will also have stabilised. This also pins down the year when the market was approximately in fundamental equilibrium. In the UK this would be about 1994. In the original paper, in Hong Kong it was about 1990.

Bubble builder-bubble burster 6 If λ 1 > 0, the lagged growth of real property prices acts in a way to perpetuate the growth of real property prices, i.e. a bubble. λ 2 > 0 captures the notion that the bubble bursts when the actual price level λ 1 drppi t-1 exceeds the equilibrium price level rppi t-1 *. If λ 1 > 0, the lagged growth of real property prices acts in a way to perpetuate the growth of real property prices, i.e. a bubble. λ 2 > 0 captures the notion that the bubble bursts when the actual price level λ 1 drppi t-1 exceeds the equilibrium price level rppi t-1 *. Putting all this together we get real property price growth: Putting all this together we get real property price growth: drppi t * = (a 0 +λ 0 )+a 1 RINT t +a 2 drrisa t +a 3 dpcrcgdp t +... drppi t * = (a 0 +λ 0 )+a 1 RINT t +a 2 drrisa t +a 3 dpcrcgdp t +......+λ 1 drppi t-1 +λ 2 (rppi t-1 *-rppi t-1 )+ε t...+λ 1 drppi t-1 +λ 2 (rppi t-1 *-rppi t-1 )+ε t

Some results – nominal interest rate These studies often start with the nominal interest rate included as a variable, but find that it drops out as insignificant in the long run. These studies often start with the nominal interest rate included as a variable, but find that it drops out as insignificant in the long run. This is a rather striking revelation. It backs up the claim made and analysed in Part One, and found in many studies, that ultimately – and contrary to much of the mortgage bank emphasis and media coverage – it is real interest rates that matter. This is a rather striking revelation. It backs up the claim made and analysed in Part One, and found in many studies, that ultimately – and contrary to much of the mortgage bank emphasis and media coverage – it is real interest rates that matter.

Some results – US, Hong Kong Hong Kong and US metropolitan cities*, tendencies towards bubbles Hong Kong and US metropolitan cities*, tendencies towards bubbles Estimated bubble builder and the bubble burster parameters were significant and comparable: Estimated bubble builder and the bubble burster parameters were significant and comparable: Bubble builder parameter: Bubble builder parameter: Hong Kong: 0.3 Hong Kong: 0.3 US metropolitan cities: 0.5 US metropolitan cities: 0.5 US remainder: 0.2 US remainder: 0.2 Bubble burster parameter: Bubble burster parameter: Hong Kong: 0.05 Hong Kong: 0.05 US metropolitan cities: 0.1 US metropolitan cities: 0.1 US remainder: 0 US remainder: 0 * Based on 30 US Metropolitan cities for the period 1977-1992 (Abraham, and Hendershott, ibid).

Some results, cont. Specifically, the coefficient on the one-period lag in ARIMA(1,1,0) was found to be large, positive and significant: in other words appreciations tend to be followed by further appreciations. Specifically, the coefficient on the one-period lag in ARIMA(1,1,0) was found to be large, positive and significant: in other words appreciations tend to be followed by further appreciations. Over the period covered, in US metropolitan cities a 1% increase in real property prices in a quarter tended to be followed by a 0.6% increase in the next quarter. Over the period covered, in US metropolitan cities a 1% increase in real property prices in a quarter tended to be followed by a 0.6% increase in the next quarter. In Hong Kong, the absence of volume changes in the number of apartments and of the real construction cost index as explanatory variables in the estimated equations was “striking” and confirmed the relative importance of demand side factors in explaining short-term property price movements. In Hong Kong, the absence of volume changes in the number of apartments and of the real construction cost index as explanatory variables in the estimated equations was “striking” and confirmed the relative importance of demand side factors in explaining short-term property price movements.

Some results, cont. In the US metropolitan cities, changes in market fundamentals and adjustment dynamics (including the bubble builder and bubble burster components) together explained about 60% of the variation in price movements and, separately, about 40%. In the US metropolitan cities, changes in market fundamentals and adjustment dynamics (including the bubble builder and bubble burster components) together explained about 60% of the variation in price movements and, separately, about 40%. On the assumption that Hong Kong prices were broadly at equilibrium in the early 90s, the upswing peaked at about 40% to 45% above fundamentals level: “This estimate is broadly consistent with market perceptions at the time.” In 1998, property prices declined by an average of 40%. On the assumption that Hong Kong prices were broadly at equilibrium in the early 90s, the upswing peaked at about 40% to 45% above fundamentals level: “This estimate is broadly consistent with market perceptions at the time.” In 1998, property prices declined by an average of 40%.

Arbitrage “To make a parrot into a learned financial economist it needs to learn just one word – arbitrage.” “To make a parrot into a learned financial economist it needs to learn just one word – arbitrage.” Stephen Ross (a learned financial economist). Arbitrage = “the simultaneous purchase and sale of the same, or essentially similar, securities in two different markets for advantageously different prices” Arbitrage = “the simultaneous purchase and sale of the same, or essentially similar, securities in two different markets for advantageously different prices” Sharpe, W., and G. Alexander, “Investments.” 4 th Edition, quoted in Shleifer, A., and R. W. Vishny, 1997. Arbitrage is at the heart of the theory of financial market efficiency. Arbitrage is at the heart of the theory of financial market efficiency. Its failure is at the heart of cases of market inefficiency and bubbles Its failure is at the heart of cases of market inefficiency and bubbles Inability to arbitrage especially at times of excess. Inability to arbitrage especially at times of excess.

Arbitrage Arbitrage is a game of co-ordination. Arbitrage is a game of co-ordination. The outcome presumed in classical finance is based on the common knowledge of all players that they are all synchronising their arbitrage strategies and that it is riskless. The outcome presumed in classical finance is based on the common knowledge of all players that they are all synchronising their arbitrage strategies and that it is riskless. In theory, the desired outcome involves no risk of capital loss. In theory, the desired outcome involves no risk of capital loss. Arbitrage: Arbitrage: Removes influence of idiosyncrasies Removes influence of idiosyncrasies Removes importance of institutional detail Removes importance of institutional detail ties price to fundamental value ties price to fundamental value Hence mispricing does not last Hence mispricing does not last

Arbitrage in practical reality… We cannot presume that agents converge on the optimal outcome in this game if this common knowledge is lacking. We cannot presume that agents converge on the optimal outcome in this game if this common knowledge is lacking. Player needs to be sure that enough other players are also arbitraging Player needs to be sure that enough other players are also arbitraging Otherwise individual acts of arbitrage are too individually risky and costly; Otherwise individual acts of arbitrage are too individually risky and costly; Most positions involve capital and risk of loss; Most positions involve capital and risk of loss; Arbitrage limited by risk-bearing capacity of arbitrageurs in the aggregate; Arbitrage limited by risk-bearing capacity of arbitrageurs in the aggregate; These risks vary across markets and institutional structures; These risks vary across markets and institutional structures; Arbitrageurs are using “other peoples’ money”…So face a principle-agent problem; Arbitrageurs are using “other peoples’ money”…So face a principle-agent problem; Arbitrage = very broad interpretation, to include, decision on house buy/sell, bank lending strategies, estate agent tactics. Arbitrage = very broad interpretation, to include, decision on house buy/sell, bank lending strategies, estate agent tactics.

Arbitrage Failure – Why no-one corrects a bubble Behavioural finance Behavioural finance Idiosyncrasies matter, psychological motivations, thought processes about each others’ thought processes, etc. Idiosyncrasies matter, psychological motivations, thought processes about each others’ thought processes, etc. Institutions matter… especially at times of excess. Institutions matter… especially at times of excess. Combining psychological with institutional… harder to rule out arbitrage failure… hence bubble-type behaviour. Combining psychological with institutional… harder to rule out arbitrage failure… hence bubble-type behaviour.

Two-sided arbitrage failure Customers don’t arbitrage Customers don’t arbitrage Mortgage banks don’t arbitrage each others’ behaviour either Mortgage banks don’t arbitrage each others’ behaviour either Mortgage banks don’t arbitrage consumers’ behaviour Mortgage banks don’t arbitrage consumers’ behaviour In times of excess it is better to exploit momentum of customers than to try to fight against it. In times of excess it is better to exploit momentum of customers than to try to fight against it.

Risks to Arbitrageurs - general Risk at various levels – the levels interact Risk at various levels – the levels interact Fundamentals risk Fundamentals risk Financing Risk/Noise Trader Risk Financing Risk/Noise Trader Risk Horizon Risk Horizon Risk Margin Risk Margin Risk Short covering risk Short covering risk No time to discuss most of this today No time to discuss most of this today Fundamentals risk (next few slides) Fundamentals risk (next few slides) Horizon Risk Horizon Risk Without fundamentals risk Without fundamentals risk E.g. Royal Dutch Shell, etc… E.g. Royal Dutch Shell, etc… With fundamentals risk With fundamentals risk Housing… Housing…

Fundamentals risk Classical finance Classical finance The greater the deviation from fundamentals the more aggressive the arbitrage since potential returns are higher. The greater the deviation from fundamentals the more aggressive the arbitrage since potential returns are higher. BUT arbitrage is a game of coordination: BUT arbitrage is a game of coordination: The less that players collectively understand that they have deviated from fundamentals, the less aggressively they collectively arbitrage. The less that players collectively understand that they have deviated from fundamentals, the less aggressively they collectively arbitrage. If an arbitrageur takes a position and then some good fundamentals news is released that justifies what had originally seemed a mispricing, the position must be closed at a loss. If an arbitrageur takes a position and then some good fundamentals news is released that justifies what had originally seemed a mispricing, the position must be closed at a loss.

Fundamentals risk Inability to define a fundamental value = two problems. Inability to define a fundamental value = two problems. More difficult to test market efficiency More difficult to test market efficiency One can never reject the null hypothesis of market efficiency when it may be that the model was misspecified. One can never reject the null hypothesis of market efficiency when it may be that the model was misspecified. Hard-to-define fundamentals make it easier for mispricing to develop in the first place. Hard-to-define fundamentals make it easier for mispricing to develop in the first place. With no unique fundamental value from which players can know (in the common knowledge sense of the word) that they have deviated, it is impossible to achieve common knowledge of deviation from fundamental value. With no unique fundamental value from which players can know (in the common knowledge sense of the word) that they have deviated, it is impossible to achieve common knowledge of deviation from fundamental value. This increases the uncertainty of players regarding the acts of other players and, hence, the uncertainty of gains from arbitrage; This increases the uncertainty of players regarding the acts of other players and, hence, the uncertainty of gains from arbitrage; Which reduces the expected payoff from any given position; which reduces the incentive to take those positions in the first place Which reduces the expected payoff from any given position; which reduces the incentive to take those positions in the first place

Fundamentals risk…housing Housing added problems: Housing added problems: Very heterogeneous asset. Very heterogeneous asset. Highly segmented market. There is no central exchange and information about the value of the underlying asset is much more imperfect. Highly segmented market. There is no central exchange and information about the value of the underlying asset is much more imperfect. Behaviour of intermediaries. Very few (do any?) estate agents price according to macroeconomic or other fundamental factors – instead they price almost always in comparison to recent local sales. Behaviour of intermediaries. Very few (do any?) estate agents price according to macroeconomic or other fundamental factors – instead they price almost always in comparison to recent local sales. Consumers - better at pricing relative to fundamentals. Consumers - better at pricing relative to fundamentals. Only very imperfect substitutes, since the risk will have been poorly, if at all, hedged. Only very imperfect substitutes, since the risk will have been poorly, if at all, hedged. Small transaction and information costs become serious impediments to arbitrage. Small transaction and information costs become serious impediments to arbitrage.

Greenspan 1 "I don't think we have a bubble in house prices. First, let's remember it's very difficult to get one. Unlike stocks, where you have a single market, low transaction costs and an ability of people to pile on nationally and cumulatively, residential housing markets are all local." "I don't think we have a bubble in house prices. First, let's remember it's very difficult to get one. Unlike stocks, where you have a single market, low transaction costs and an ability of people to pile on nationally and cumulatively, residential housing markets are all local." Federal Reserve Chairman Alan Greenspan, 17 April 2002, Testimony before the Joint Economic Committee.

Greenspan 2 Greenspan emphasises entry of speculators – perhaps day- traders with low transactions costs, able to ‘pile on’, as Greenspan puts it, and generate herd behaviour and bubbles. Greenspan emphasises entry of speculators – perhaps day- traders with low transactions costs, able to ‘pile on’, as Greenspan puts it, and generate herd behaviour and bubbles. But entry is not the only issue in a bubble phase; correction, via acts of arbitrage, is important too. But entry is not the only issue in a bubble phase; correction, via acts of arbitrage, is important too. Day traders can also easily ‘pile out’, correcting the market. We can’t immediately presume that the power of the first dominates the latter (the very knowledge of the ability to ‘pile out’ may itself act as a corrective influence). Day traders can also easily ‘pile out’, correcting the market. We can’t immediately presume that the power of the first dominates the latter (the very knowledge of the ability to ‘pile out’ may itself act as a corrective influence). Arbitrage is a double-edged sword; just as rational agents arbitrage away inefficient pricing, irrational traders arbitrage away efficient pricing. Arbitrage is a double-edged sword; just as rational agents arbitrage away inefficient pricing, irrational traders arbitrage away efficient pricing. If each group has significant risk-bearing capacity, both will influence the price. If each group has significant risk-bearing capacity, both will influence the price. The ability of the first group to offset the second group is very weak in housing markets. The ability of the first group to offset the second group is very weak in housing markets.

Substitutes, Short-Run Supply, and Short Sales Arbitrage needs close substitutes Arbitrage needs close substitutes Arbitrageur goes short the expensive security and long very similar but cheaper securities Arbitrageur goes short the expensive security and long very similar but cheaper securities Works even if some agents are not fully rational Works even if some agents are not fully rational Even if demands are correlated Even if demands are correlated Price determined relative to close substitute and NOT the absolute supply of the asset Price determined relative to close substitute and NOT the absolute supply of the asset So, may achieve “Law of One Price” in shares to one company even if not of whole market. So, may achieve “Law of One Price” in shares to one company even if not of whole market.

Equities substitutability Equities weak substitutability Equities weak substitutability Roll, 1988 Roll, 1988 Amount of variation in return on large stocks explained by aggregate economic factors, returns on other stocks in the same sector, and firm- specific publicly-known news. Amount of variation in return on large stocks explained by aggregate economic factors, returns on other stocks in the same sector, and firm- specific publicly-known news. 35% on monthly data. 35% on monthly data. 25% on daily data. 25% on daily data. In other words, there is very little substitutability between even equities. In other words, there is very little substitutability between even equities.

Substitutability… Even if individual securities have better substitutes than the whole market, many broad categories do not have substitute portfolios. Even if individual securities have better substitutes than the whole market, many broad categories do not have substitute portfolios. Risky to get in and out of shares as a class given given high historical rate of return. Risky to get in and out of shares as a class given given high historical rate of return. Housing – only strategy if there is suspected overpriced is to get out altogether, with intent to get back in later when price is lower: Housing – only strategy if there is suspected overpriced is to get out altogether, with intent to get back in later when price is lower: But very risky. But very risky. Housing also has no (or low) ‘release valve’ of international trade, unlike equity. Housing also has no (or low) ‘release valve’ of international trade, unlike equity.

Inability to go short in housing Creates an asymmetry Creates an asymmetry Can’t exploit profit opportunities if market expected to decline (c.f. can in principle in equity markets). Can’t exploit profit opportunities if market expected to decline (c.f. can in principle in equity markets). Buy-and-hold in periods of excess positive return Buy-and-hold in periods of excess positive return Asymmetry feeds bank expectations of how to exploit volatility. Asymmetry feeds bank expectations of how to exploit volatility. Feeds bubbles. Feeds bubbles.

Replicability of asset The more easy it is to create substitutes to current assets, the less likely it is to get a bubble. The more easy it is to create substitutes to current assets, the less likely it is to get a bubble. Affects interpretation of slow supply response of housing … as not just a determinant of ‘fundamentals’ … but as a ‘bubble’-generating feature too. Affects interpretation of slow supply response of housing … as not just a determinant of ‘fundamentals’ … but as a ‘bubble’-generating feature too. Normally the ex ante knowledge that excess price relative to fundamentals will draw forth extra supply of underlying asset, acts to numb price pressure Normally the ex ante knowledge that excess price relative to fundamentals will draw forth extra supply of underlying asset, acts to numb price pressure Slow supply response feeds episodes of mispricing Slow supply response feeds episodes of mispricing Supply lags – long planning and build process - exaggerate boom-bust cycle. Supply lags – long planning and build process - exaggerate boom-bust cycle. Option based component to when high uncertainty about fundamentals… resist supplying till some of the uncertainty is resolved Option based component to when high uncertainty about fundamentals… resist supplying till some of the uncertainty is resolved

Diversification, Liquidity and Arbitrage Portfolio theory Portfolio theory Should be well-diversified. Should be well-diversified. In the limit (though taking into consideration transactions costs) should participate in all securities markets In the limit (though taking into consideration transactions costs) should participate in all securities markets Should not over-invest in assets that correlate with own income Should not over-invest in assets that correlate with own income Plenty of equity evidence that workers do oveinvest in own firm stock) Plenty of equity evidence that workers do oveinvest in own firm stock) Standard arbitrage notion is that small number of marginal positions, with limited extra exposure Standard arbitrage notion is that small number of marginal positions, with limited extra exposure

Diversification, Liquidity and Arbitrage… Not work well in housing Not work well in housing Most players not well diversified… heavily exposed to this one asset Most players not well diversified… heavily exposed to this one asset Most decisions are not marginal… Most decisions are not marginal… We tend to rely on large-value decisions by small number of arbitrageurs (first-time buyers, etc…. one of the lest experienced categories of investors) We tend to rely on large-value decisions by small number of arbitrageurs (first-time buyers, etc…. one of the lest experienced categories of investors) Encouraged by tax system Encouraged by tax system Principle residence is tax advantaged, buy-to-let sales generate capital gains liability Principle residence is tax advantaged, buy-to-let sales generate capital gains liability Besides, even well-diversified arbitrageurs find that markets tend to fall in a correlated fashion. Besides, even well-diversified arbitrageurs find that markets tend to fall in a correlated fashion.

Liquidity Liquidity - smart traders can arbitrage mispricing. Liquidity - smart traders can arbitrage mispricing. But liquidity makes it easier for foolish traders to arbitrage away efficient pricing. But liquidity makes it easier for foolish traders to arbitrage away efficient pricing. Those in housing are less liquid. Those in housing are less liquid. Irrational entrants “more liquid”. Irrational entrants “more liquid”. Falling market = forces sales into highly illiquid market. Falling market = forces sales into highly illiquid market.

Housing market problems: Summary The market is dominated by individuals who only trade in their own home. The market is dominated by individuals who only trade in their own home. High transactions costs, carrying costs, and tax considerations make it relatively difficult for professionals to take advantage of profitable arbitrage opportunities when the market is overvalued. High transactions costs, carrying costs, and tax considerations make it relatively difficult for professionals to take advantage of profitable arbitrage opportunities when the market is overvalued. Markets are local (in the sense that house purchase decisions are related to many other aspects of the buyer’s location) reducing the willingness to arbitrage across markets. Markets are local (in the sense that house purchase decisions are related to many other aspects of the buyer’s location) reducing the willingness to arbitrage across markets. And the inability to hedge – no futures or options market. And the inability to hedge – no futures or options market. All this dramatically reduces the aggressiveness of arbitrageurs. All this dramatically reduces the aggressiveness of arbitrageurs. With arbitrageurs discouraged, markets become more open to momentum and panic-based inefficiencies With arbitrageurs discouraged, markets become more open to momentum and panic-based inefficiencies

Central banks exacerbate arbitrage problems…bubbles worse? Usual rationally-determined, ‘put’ option generated by central bank asymmetric behaviour. Usual rationally-determined, ‘put’ option generated by central bank asymmetric behaviour. In the housing market context this refers to that part of house prices that factors in the value of the downside insurance that buyers and lenders perceive (rightly or wrongly) on account of the central bank’s willingness to act vigorously when prices fall, though being less willing to act when prices rise. Just as an investor can set a floor to the price of a security by buying a put option, so the central bank can set a floor for house prices by cutting interest rate when prices go too low for their liking. At the same time there is no call option, or ceiling, on house prices such that a rise in interest rates would be triggered. Of course, the ability of the central bank to make good on the ‘put’ option is another matter altogether. What consumers believe and what the central bank is able to deliver may be very different. In the housing market context this refers to that part of house prices that factors in the value of the downside insurance that buyers and lenders perceive (rightly or wrongly) on account of the central bank’s willingness to act vigorously when prices fall, though being less willing to act when prices rise. Just as an investor can set a floor to the price of a security by buying a put option, so the central bank can set a floor for house prices by cutting interest rate when prices go too low for their liking. At the same time there is no call option, or ceiling, on house prices such that a rise in interest rates would be triggered. Of course, the ability of the central bank to make good on the ‘put’ option is another matter altogether. What consumers believe and what the central bank is able to deliver may be very different.

Central banks exacerbate arbitrage problems? Extra, behavioural, angle. Extra, behavioural, angle. Central bank asymmetrically alters the uncertainty of those (house buyers/mortgage banks) who would arbitrage = increase incidence of behaviourally generated bubbles. Central bank asymmetrically alters the uncertainty of those (house buyers/mortgage banks) who would arbitrage = increase incidence of behaviourally generated bubbles. Arbitragers, when trying to correct a bubble, find that the central bank effectively works against them, and this is, ex ante, factored into the strength of their arbitrage and their ability to correct momentum behaviour, and this is, ex ante, factored into the behaviour of those engaging in bubble-type behaviour. Arbitragers, when trying to correct a bubble, find that the central bank effectively works against them, and this is, ex ante, factored into the strength of their arbitrage and their ability to correct momentum behaviour, and this is, ex ante, factored into the behaviour of those engaging in bubble-type behaviour.

Psychological biases of house buyers Biases Biases feed bubble-type behaviour. feed bubble-type behaviour. Make arbitrage harder. Make arbitrage harder. Optimism and similar biases Optimism and similar biases 98% of confidence intervals only contain the true value 60% of the time 98% of confidence intervals only contain the true value 60% of the time “Illusion of control” “Illusion of control” exaggerate ability to control own situation exaggerate ability to control own situation “Self-attribution/confirmation bias” “Self-attribution/confirmation bias” Tendency to interpret investment successes as confirming own abilities Tendency to interpret investment successes as confirming own abilities

Optimism... “Availability cascades” “Availability cascades” Ballooning number of TV programs reassure that prices an only ever go up. Ballooning number of TV programs reassure that prices an only ever go up. A few optimists (buy-to-lets?) capable of driving prices above fundamentals…given no short selling possible, few active traders. A few optimists (buy-to-lets?) capable of driving prices above fundamentals…given no short selling possible, few active traders. Seek confirmatory information. Hirschliefer evidence that excessive attachment to activities on which we have expended a lot of resources. Seek confirmatory information. Hirschliefer evidence that excessive attachment to activities on which we have expended a lot of resources.

Why don’t optimists die out? Sort of Darwinian selection Sort of Darwinian selection It doesn’t work It doesn’t work Upward trend in prices means optimists survive and those being ‘more rational’ fall as percent of population Upward trend in prices means optimists survive and those being ‘more rational’ fall as percent of population Note role of banks in this… they have to feed the ability to borrow against collateral value Note role of banks in this… they have to feed the ability to borrow against collateral value So…this is also a story about ‘optimist banks crowding out ‘rational’ banks So…this is also a story about ‘optimist banks crowding out ‘rational’ banks And hence a story about ‘bank bubbles’ and equity valuation of banks. And hence a story about ‘bank bubbles’ and equity valuation of banks.

Momentum reasoning Empirical/experimental evidence that agents ignore laws of probability. Empirical/experimental evidence that agents ignore laws of probability. Kahnemann and Tversky 1974, ‘representative heuristic’… subjects extrapolate short time series. Kahnemann and Tversky 1974, ‘representative heuristic’… subjects extrapolate short time series. Currently low nominal interest rates and ‘burden of debt low’. Currently low nominal interest rates and ‘burden of debt low’. Forget not repaying debt so quickly as in the past. Forget not repaying debt so quickly as in the past.

Some loan rates and loan sizes Percent burden of monthly payments after SalaryMortgage rate Monthly repayment Inflation rate Wage inflation1 year5 years10years25yearslifetime 1 30,000100,000 10% £918 7%9%34%24%16%4%15% 2 30,000155,300 5% £918 7%9%34%24%16%4%15% 3 30,000155,300 5% £918 2%4%35%30%25%14%23% 4 30,000100,000 5% £591 2%4%23%19%16%9%15%

Shift in loan repayment schedule

Consumers bid out debt

Anchoring, regret, and disposition effects House price anchoring House price anchoring Northcraft and Neale 1987 Northcraft and Neale 1987 Regret Regret The disposition effect and house price stickiness The disposition effect and house price stickiness Dislike losses more than the enjoy gains Dislike losses more than the enjoy gains Genesove and Mayer (2001) find a ‘disposition effect’ in housing. Genesove and Mayer (2001) find a ‘disposition effect’ in housing. Falling downtown Boston housing market in the 1990s, owners facing negative equity tended to set prices at 25% - 35% of the difference between the property’s expected selling price and their original purchase price Falling downtown Boston housing market in the 1990s, owners facing negative equity tended to set prices at 25% - 35% of the difference between the property’s expected selling price and their original purchase price consequently, they held out too long and made an even greater loss consequently, they held out too long and made an even greater loss

Anchoring, regret, and disposition effects… See similar behaviour in private rentals markets, when owners would rather take another month without a tenant then chip 5% of the rent See similar behaviour in private rentals markets, when owners would rather take another month without a tenant then chip 5% of the rent Helps explain part of the fall in volumes of housing market trade at a peak before prices come down, and why house price falls in the early stages of a collapse can be slow. Helps explain part of the fall in volumes of housing market trade at a peak before prices come down, and why house price falls in the early stages of a collapse can be slow. Evidence too of price stickiness: Evidence too of price stickiness: Sellers compare their selling price to the selling price of other homes nearby. Sellers compare their selling price to the selling price of other homes nearby. Hard to coordinate price drops if each seller does not want to be the first to cut. Hard to coordinate price drops if each seller does not want to be the first to cut. This, too, feeds the potentially slow onset of the unwinding from a bubble. This, too, feeds the potentially slow onset of the unwinding from a bubble. Less resistance to price rises in the bubble phase, this generates a ratchet effect. Less resistance to price rises in the bubble phase, this generates a ratchet effect.

Transaction costs and mispricing Fama (1991) efficient market is one where “deviations from the extreme version of the efficiency hypothesis are within information and transactions costs”. We need to understand, therefore, whether transactions costs can cause a degree of volatility that is even greater than the efficient level of volatility. In a world with momentum traders, it can be. Fama (1991) efficient market is one where “deviations from the extreme version of the efficiency hypothesis are within information and transactions costs”. We need to understand, therefore, whether transactions costs can cause a degree of volatility that is even greater than the efficient level of volatility. In a world with momentum traders, it can be.

Transaction costs and housing market ‘frenzy’ High and lumpy transactions costs High and lumpy transactions costs Brokerage fees. Brokerage fees. Buyers’ and sellers’ search costs. Buyers’ and sellers’ search costs. Moving costs. Moving costs. Capital gains costs (for buy-to-lets who decide to temporarily sell out in an overvalued market). Capital gains costs (for buy-to-lets who decide to temporarily sell out in an overvalued market). Tax on interest earned from holding cash rather than property while waiting for correction, etc. Tax on interest earned from holding cash rather than property while waiting for correction, etc. This reinforces the illiquidity of the market. This reinforces the illiquidity of the market. Empirical studies further find that lumpy transaction costs lead to important nonlinearities in price dynamics. Empirical studies further find that lumpy transaction costs lead to important nonlinearities in price dynamics.

Transaction costs and housing market ‘frenzy’… The large fixed element of transactions costs influences the choice between buying and renting, and whether to trade up. The large fixed element of transactions costs influences the choice between buying and renting, and whether to trade up. In periods of greater appreciation of house prices, more households are pulled over the transactions cost hurdle to engage in momentum trade, in the expectation of capital gain. In periods of greater appreciation of house prices, more households are pulled over the transactions cost hurdle to engage in momentum trade, in the expectation of capital gain. At these times of heightened activity – of ‘frenzy’ – increased demand feeds back into higher prices and further demand. At these times of heightened activity – of ‘frenzy’ – increased demand feeds back into higher prices and further demand.

Frenzy effect Behavioural/arbitrage failure framework. Behavioural/arbitrage failure framework. In stable periods both consumers and banks are more likely to behave in ways that arbitrage the market. In stable periods both consumers and banks are more likely to behave in ways that arbitrage the market. Many speculative agents keep out and the market is less likely to deviate from fundamentals for long periods of time, and arbitrageurs – both banks and house buyers – are less likely to be ‘punished’ for doing their job. Many speculative agents keep out and the market is less likely to deviate from fundamentals for long periods of time, and arbitrageurs – both banks and house buyers – are less likely to be ‘punished’ for doing their job. Unstable, ‘frenzy’, periods agents stop arbitraging the market since it is too dangerous Unstable, ‘frenzy’, periods agents stop arbitraging the market since it is too dangerous Prices may deviate even further from fundamentals as many speculative agents enter, and arbitrageurs are much more likely to be ‘punished’ for trying to correct the market. Prices may deviate even further from fundamentals as many speculative agents enter, and arbitrageurs are much more likely to be ‘punished’ for trying to correct the market.

Frenzy effect… Phasing out of mortgage tax relief over the 1990s should have helped to cool market by giving less benefit to owners than to renters Phasing out of mortgage tax relief over the 1990s should have helped to cool market by giving less benefit to owners than to renters Recent ‘frenzy’ must have been particularly severe. Recent ‘frenzy’ must have been particularly severe. Low nominal rates have fed agents’ ability to ‘go with the frenzy’. Low nominal rates have fed agents’ ability to ‘go with the frenzy’. The number of houses on estate agents’ books is a function of the ‘frenzy’ effect. The number of houses on estate agents’ books is a function of the ‘frenzy’ effect. In ‘frenzy’ periods the flow off estate agents’ books is greater than the flow on. In ‘frenzy’ periods the flow off estate agents’ books is greater than the flow on. In bust periods the resistance to price cuts means that the flow off the books falls relative to the flow on. In bust periods the resistance to price cuts means that the flow off the books falls relative to the flow on. Casually asserting that stock on the books is a measure of fundamentals supply and demand conditions is simply wrong Casually asserting that stock on the books is a measure of fundamentals supply and demand conditions is simply wrong

Frenzy effect… The ‘disposition effect’, price stickiness and ‘frenzy’ effect, together mean that housing on estate agents’ books and trading volume are good leading indicators of future price changes. The ‘disposition effect’, price stickiness and ‘frenzy’ effect, together mean that housing on estate agents’ books and trading volume are good leading indicators of future price changes. Econometric evidence for ‘frenzy’ behaviour in housing markets: Econometric evidence for ‘frenzy’ behaviour in housing markets: Muellbauer, J., and A. Murphy, 1997; Hendry, D.F., 1984; Quigley, J.M., 1999; Case, B., and J.M. Quigley, 1991; and Hall, R.E., 1978. Muellbauer, J., and A. Murphy, 1997; Hendry, D.F., 1984; Quigley, J.M., 1999; Case, B., and J.M. Quigley, 1991; and Hall, R.E., 1978.

Frenzy effect “Without such a nonlinearity or dummies for the spikes in the data, the equation standard error more than doubles”. They find that by taking the frenzy component and downside risk term out, the shift in the income growth component and the 1980s real interest rate effect become “quite insignificant”. In conclusion they comment: “These results suggest that the omission of a non-linear ‘frenzy’ effect is a major specification error. The omission worsens the fit and fails to support the predictions of economic theory regarding the consequences of financial liberalisation, which are supported by a better specified model including a ‘frenzy’ effect.” Muellbauer, J., and A. Murphy, 1997

Frenzy effect… But most mortgage bank analysts use models based on efficient markets reasoning that ignores the possibility of such effects. But most mortgage bank analysts use models based on efficient markets reasoning that ignores the possibility of such effects. This also explains why zero house price growth can be serious news for a market that has recently experienced ‘frenzy’. Price rises are no longer high enough to draw many over the threshold and the market grinds to a halt…before declining. This also explains why zero house price growth can be serious news for a market that has recently experienced ‘frenzy’. Price rises are no longer high enough to draw many over the threshold and the market grinds to a halt…before declining.

Survey evidence So how do house buyers think? In ways likely to make the market more or less easy to arbitrage? So how do house buyers think? In ways likely to make the market more or less easy to arbitrage? The nearest thing we have to a controlled laboratory experiment in housing was performed by Case and Shiller* in the US on two boom cities, a post-boom city and a control city with fairly constant macroeconomic fundamentals. The nearest thing we have to a controlled laboratory experiment in housing was performed by Case and Shiller* in the US on two boom cities, a post-boom city and a control city with fairly constant macroeconomic fundamentals. Identical questionnaires of actual home buyers, and found the following results. Identical questionnaires of actual home buyers, and found the following results. *Case, K.E., and R. J. Shiller, 1988 (also found in Shiller, R.J., 1989, p403-430).

Survey evidence – four cities Four cities facing fairly similar macroeconomic fundamentals: Four cities facing fairly similar macroeconomic fundamentals: Two boom cities, a post-boom city and a control city. Two boom cities, a post-boom city and a control city. [Boom cities: Anaheim and California. Post boom city: Boston. Control city (where no price changes in past five years): Milwaukee] [Boom cities: Anaheim and California. Post boom city: Boston. Control city (where no price changes in past five years): Milwaukee] Identical questionnaires of actual home buyers Identical questionnaires of actual home buyers Big issues were expectations about housing asset prices and risk of capital loss. Big issues were expectations about housing asset prices and risk of capital loss.

Miles Report Interesting reading alongside recent evidence on assessments of interest rates and ultimate cost of housing – including the ‘Miles Review’ of the UK housing market (H.M. Treasury, December 2003): Interesting reading alongside recent evidence on assessments of interest rates and ultimate cost of housing – including the ‘Miles Review’ of the UK housing market (H.M. Treasury, December 2003): House buyers overly-optimistic about future interest rates House buyers overly-optimistic about future interest rates Under-influenced by risks of future changes in interest charge Under-influenced by risks of future changes in interest charge Irrationally influenced by current-period cost of loan and current period nominal interest rate deals Irrationally influenced by current-period cost of loan and current period nominal interest rate deals ‘Miles Review’ describes people as openly ‘laughing’, according to some studies, when asked to predict the cost of loans by forming assessments of future interest rates ‘Miles Review’ describes people as openly ‘laughing’, according to some studies, when asked to predict the cost of loans by forming assessments of future interest rates

What triggered the booms? There was no exogenous trigger for the housing price booms. There was no exogenous trigger for the housing price booms. In all four cities interest rate changes were cited as a major factor. However, at the time, interest rates were virtually identical. The same interest rates got the credit for the boom in California and the blame for the stagnation in Boston. Price changes could not have been driven in all four cities by interest rates! In all four cities interest rate changes were cited as a major factor. However, at the time, interest rates were virtually identical. The same interest rates got the credit for the boom in California and the blame for the stagnation in Boston. Price changes could not have been driven in all four cities by interest rates!

Knowledge of fundamentals There was evidence of strong investment motivation and higher price expectations in the boom cities than the control city, but these were “expectations that they could not show any ability to justify...Since most people expressed a strong investment motive, one would assume significant knowledge of underlying market fundamentals. The efficient markets hypothesis assumes that asset buyers make rational decisions based on all available information and based on a consistent model of underlying market forces...The survey reveals little real knowledge of or, agreement about, the underlying causes of price movements. Rather then citing any concrete evidence, people retreat into clichés....” There was evidence of strong investment motivation and higher price expectations in the boom cities than the control city, but these were “expectations that they could not show any ability to justify...Since most people expressed a strong investment motive, one would assume significant knowledge of underlying market fundamentals. The efficient markets hypothesis assumes that asset buyers make rational decisions based on all available information and based on a consistent model of underlying market forces...The survey reveals little real knowledge of or, agreement about, the underlying causes of price movements. Rather then citing any concrete evidence, people retreat into clichés....”

Local economy? The second most-cited feature was a “strong local economy.” The second most-cited feature was a “strong local economy.” Yet “None...cited any specific evidence of such strength or any detail about its character...people look to observed price movements to form their expectations and then look around for a logic to explain and reinforce their beliefs.” Yet “None...cited any specific evidence of such strength or any detail about its character...people look to observed price movements to form their expectations and then look around for a logic to explain and reinforce their beliefs.”

Quantitative evidence? Many (in the boom city and post boom city, but not in the control group) cited that there was “not enough land”. But this is not news and cannot explain a sudden boom. Many (in the boom city and post boom city, but not in the control group) cited that there was “not enough land”. But this is not news and cannot explain a sudden boom. “An especially striking feature.... not a single respondent referred to explicit quantitative evidence relevant to future supply or demand for housing... one would expect some to volunteer such evidence if it figured prominently in their views.” “An especially striking feature.... not a single respondent referred to explicit quantitative evidence relevant to future supply or demand for housing... one would expect some to volunteer such evidence if it figured prominently in their views.” People seem to form expectations on the basis of past price movements rather than any knowledge of fundamentals. Essentially, home buyers become destabilising speculators. People seem to form expectations on the basis of past price movements rather than any knowledge of fundamentals. Essentially, home buyers become destabilising speculators.

Price feedback This, and stock market studies, conclude that the feedback of price changes on price dynamics is important. This, and stock market studies, conclude that the feedback of price changes on price dynamics is important. In stock markets, the feedback is very rapid – a downward price movement attracts attention leading to further price declines within a day or so. In stock markets, the feedback is very rapid – a downward price movement attracts attention leading to further price declines within a day or so. In real estate, price increases attract attention and contribute to increasing prices over a year or so. In real estate, price increases attract attention and contribute to increasing prices over a year or so. Asked whether price increases influenced their decision to buy: Asked whether price increases influenced their decision to buy: Boom cities: 90% Boom cities: 90% Control city: 84.8% Control city: 84.8% Post-boom city: 77.8% Post-boom city: 77.8% 25% overall expressed a fear of never being able to get into the market. 25% overall expressed a fear of never being able to get into the market. 65% in the boom market expressed this fear. 65% in the boom market expressed this fear.

Attitude to risk Willingness to pay for an asset is related to perceived risk. Willingness to pay for an asset is related to perceived risk. “Very few of the home buyers in any of the four cities thought that the housing market involved a great deal of risk... (even where openly speculating about crash)”. The degree of risk perceived was lowest in the boom markets. “Very few of the home buyers in any of the four cities thought that the housing market involved a great deal of risk... (even where openly speculating about crash)”. The degree of risk perceived was lowest in the boom markets. “ Rising prices seem to dampen fears, and that may well fuel the boom.” Practically all buyers in the two boom markets and the vast majority in the post-boom and control groups believed that prices were bound to increase, reflecting the popular myth that “one cannot lose in this market; houses are always a safe investment, so long as one holds out long enough.” “ Rising prices seem to dampen fears, and that may well fuel the boom.” Practically all buyers in the two boom markets and the vast majority in the post-boom and control groups believed that prices were bound to increase, reflecting the popular myth that “one cannot lose in this market; houses are always a safe investment, so long as one holds out long enough.”

More on risk There is the same curious attitude towards risk in housing markets as can be found in overvalued stock markets. Recent research suggests that a recent period of good times leads investors to have an extraordinary high tolerance for risk, and accept relatively low expected returns to holding stocks (Campbell and Cochrane 1999) and hence equity valuations rise. Unfortunately, this contrasts with survey evidence on investor expectations in that they expect high returns on stocks in the future, not the low returns that they supposedly accept because they are especially risk-tolerant (Durell 99). The two things are totally irreconcilable – one of them has to be give. As Case and Shiller put it in housing markets: “Prices are high because investors expect them to go even higher not because they are ready for prices to go down.” There is the same curious attitude towards risk in housing markets as can be found in overvalued stock markets. Recent research suggests that a recent period of good times leads investors to have an extraordinary high tolerance for risk, and accept relatively low expected returns to holding stocks (Campbell and Cochrane 1999) and hence equity valuations rise. Unfortunately, this contrasts with survey evidence on investor expectations in that they expect high returns on stocks in the future, not the low returns that they supposedly accept because they are especially risk-tolerant (Durell 99). The two things are totally irreconcilable – one of them has to be give. As Case and Shiller put it in housing markets: “Prices are high because investors expect them to go even higher not because they are ready for prices to go down.”

Residential yields Net UK average residential yields (GSISG figures)

Risk premia Net U.K. Average Residential Rental Yield less real 20 Year Government Bond Yield (GSISG calculation)

Thoughts on risky assets

Volatility of house prices Volatility in real house prices HMT p41

‘Self-awareness’ of psychological influences In stock market surveys people are much more aware of possible investor psychology explanations for price rises, whereas “most participants in housing markets do not attribute market events to psychology of other investors” (Not surprisingly, the highest percent who did, 18%, was in the post-boom city). “Perhaps we should conclude that social psychology is an important factor in transmission of [housing] booms, but that individuals’ perceptions of the psychology of others are less so.” In stock market surveys people are much more aware of possible investor psychology explanations for price rises, whereas “most participants in housing markets do not attribute market events to psychology of other investors” (Not surprisingly, the highest percent who did, 18%, was in the post-boom city). “Perhaps we should conclude that social psychology is an important factor in transmission of [housing] booms, but that individuals’ perceptions of the psychology of others are less so.”

After the survey Two years after the survey, a major bust started in the boom cities, wiping 20+% off prices (the typical down-payment of first-time home buyers in those cities, 98% of whom had been convinced prices would rise and 63% of whom had said they faced little or no risk). Two years after the survey, a major bust started in the boom cities, wiping 20+% off prices (the typical down-payment of first-time home buyers in those cities, 98% of whom had been convinced prices would rise and 63% of whom had said they faced little or no risk).

Consumption and House Prices 1970-mid 1990s, rapid increase in house prices (green line) accompanied by rapid growth of consumption (red line) Recently, house price inflation has accelerated but the rate of growth of consumption has steadied. Source: Bank of England Inflation Report May 2004, p12, Chart 2.1.

A breakdown? Misleading causation. Misleading causation. Both driven by income expectations? Not directly observable. Both driven by income expectations? Not directly observable. Credit constraints? Credit constraints? A very different central bank response next time? A very different central bank response next time?

More evidence: durables and non-durables Real durable and semi-durables consumption is highly pro-cyclical. But need to adjust for rapid price falls of durable goods (global price falls, etc.)… Source: Bank of England Quarterly Bulletin, Spring 2004, J Power, Chart 1.

Nominal ratio of durable to non- durable consumption Source: Bank of England Quarterly Bulletin Spring 2004, J Power, Chart 11. Source: Bank of England Quarterly Bulletin Spring 2004, J Power, Chart 11.

Real house prices and share of durable spending in consumption Durables more likely purchased on credit. Share previously very correlated with house prices. Correlation has broken down since the late 1990s. Source: Bank of England Inflation Report November 2004

More Evidence Swings – in all periods – in spending relative to income of homeowners is nearly as great as renters. But: risk premia and options thinking of owners, etc. Source: BOE Inflation Report May 2004, p12, Chart 2.3, based on the Family Expenditure Survey.

Possibilities Credit constraints less important? Credit constraints less important? No upwards revision in expected future earnings and wealth? No upwards revision in expected future earnings and wealth? This would have driven higher housing demand (and house prices) and higher desired stock of durables. This would have driven higher housing demand (and house prices) and higher desired stock of durables. Flow increase in durables expenditure on the path to new desired stock level. Flow increase in durables expenditure on the path to new desired stock level.

Awkward Conclusions If real income expectations are pretty stable, how could these have driven house prices so much higher? If real income expectations are pretty stable, how could these have driven house prices so much higher? Not enough ability of demographic factors and the slow rate of house build to explain house price rises. Not enough ability of demographic factors and the slow rate of house build to explain house price rises. Great deal of weight placed on a credit constraint story for house price rises. Great deal of weight placed on a credit constraint story for house price rises. But difficult to create a consistent story if credit constraints are highly important for housing consumption but not for non-housing consumption, especially durables. But difficult to create a consistent story if credit constraints are highly important for housing consumption but not for non-housing consumption, especially durables.

Or… Very high real house prices (and/or low interest rates) are not regarded as long-term sustainable by the general public? Very high real house prices (and/or low interest rates) are not regarded as long-term sustainable by the general public? Also some distributional issues – since rapidly rising house prices (relatively) redistribute wealth from asset-poor to already asset-rich, from young to old. And this feeds subtle differences in aggregate consumption behaviour. Also some distributional issues – since rapidly rising house prices (relatively) redistribute wealth from asset-poor to already asset-rich, from young to old. And this feeds subtle differences in aggregate consumption behaviour.

Mortgage Equity Withdrawal 0% of household income in the late 1990s Now over 8% today Yet, consumption as a percent of household disposable income has hardly changed (1997- today) What if MEW were to collapse this time? Source: Bank of England Inflation Report May 2004, p 13, Chart 2.4.

Correlation between annual house price inflation and annual consumption growth 10 year rolling correlation coefficient has collapsed Source: Bank of England Inflation Report November 2004, p12 Chart B.

Need to correct for… Demutualisation of building societies. Windfall payments (fungible with MEW) of £35 billion, or 7% of annual consumption, helped the jump from 90% to 96% in two years with hardly any change in MEW. Demutualisation of building societies. Windfall payments (fungible with MEW) of £35 billion, or 7% of annual consumption, helped the jump from 90% to 96% in two years with hardly any change in MEW. Introduction of self-assessment. Introduction of self-assessment. The relationship is still weaker than in the past but nevertheless is more positive than it first appears. The relationship is still weaker than in the past but nevertheless is more positive than it first appears.

The big consumption story? Levels v. stocks: The surge in the level of consumption from 86% to 96% of household disposable income created high rates of growth of consumption in the 1980s. Levels v. stocks: The surge in the level of consumption from 86% to 96% of household disposable income created high rates of growth of consumption in the 1980s. Recent consumption has run consistently at a much higher level for much of the last 7-8 years (with 3%- 5% consumption growth per year). Recent consumption has run consistently at a much higher level for much of the last 7-8 years (with 3%- 5% consumption growth per year). The big consumption story of the late 1990s and early 2000s is the historically high level of consumption from disposable income, low levels of savings, and deteriorating pension provision. The big consumption story of the late 1990s and early 2000s is the historically high level of consumption from disposable income, low levels of savings, and deteriorating pension provision.

More on MEW Insignificant in the UK up to 1980. 1980s liberalization. No other country in the EU ever managed anywhere near to 8%. 1979-1999 Germany, France, and Italy net injection of 6% of household income into housing. Source: Bank of England, Office for National Statistics and HM Treasury calculations. Chart 5.5, HMT 2004 p52, not updated.

Key MEW findings 50%-60% is last-time sellers and those trading down, i.e. those most likely to pay off debt and save. 50%-60% is last-time sellers and those trading down, i.e. those most likely to pay off debt and save. A large proportion that is spent goes on ‘home improvement’ and ‘new goods for the home’. A large proportion that is spent goes on ‘home improvement’ and ‘new goods for the home’. But, house prices and MEW are partly endogenous to any price bubble (family transfers, home improvement). But, house prices and MEW are partly endogenous to any price bubble (family transfers, home improvement). Borrowers who withdraw to spend are concentrated at higher incomes, but a sizeable proportion are on low incomes, and their borrowings are relatively high- level. Borrowers who withdraw to spend are concentrated at higher incomes, but a sizeable proportion are on low incomes, and their borrowings are relatively high- level. Low levels of serial remortgaging. Low levels of serial remortgaging.

MEW and housing market Transactions UK has one of the highest rates of housing market transaction in the EU. Transactions volumes matter if most current MEW is released through last-time sales and trading down. Source: HMT Table 5.4, p51. Source: Bank of England and Office for National Statistics.

MEW cont. MEW is more lumpy than many credit constraint stories suggest, which is why so much MEW is immediately saved and then generates a later flow. MEW is more lumpy than many credit constraint stories suggest, which is why so much MEW is immediately saved and then generates a later flow. Much of the consumption flow from recent MEW is still to come. More stabilizing? Much of the consumption flow from recent MEW is still to come. More stabilizing? If MEW plummets, there is no new flow into the stock of assets to generate new consumption flow. Less stabilizing? If MEW plummets, there is no new flow into the stock of assets to generate new consumption flow. Less stabilizing? In ‘turning’, or stagnant, housing markets, prices do not fall heavily at first; transactions do. The liquidity of the market and ability to ‘release’ equity falls.Those wanting to trade-down are heavily dependent on chains of buyers. Their ability to release MEW falls. In ‘turning’, or stagnant, housing markets, prices do not fall heavily at first; transactions do. The liquidity of the market and ability to ‘release’ equity falls.Those wanting to trade-down are heavily dependent on chains of buyers. Their ability to release MEW falls.

But… Only element of MEW that seems not cyclical is remortgaging (but evidence is hard to interpret). Only element of MEW that seems not cyclical is remortgaging (but evidence is hard to interpret). For those forms of MEW that involve borrowing…debt bites much more in a low inflation environment. For those forms of MEW that involve borrowing…debt bites much more in a low inflation environment. What if those borrowing on MEW are excessively buying into the house ‘price rise’? What if those borrowing on MEW are excessively buying into the house ‘price rise’? If MEW replaces ‘more expensive’ forms of debt…this dries up if house prices fall. If MEW replaces ‘more expensive’ forms of debt…this dries up if house prices fall. A small consumption response can still be magnified by a big collapse in MEW. A small consumption response can still be magnified by a big collapse in MEW. If prices fall, there will be a collapse in MEW. If prices fall, there will be a collapse in MEW.

Demographics of MEW Withdrawal of equity by last-time sellers is much greater than injection by first-time sellers. Stock of debt naturally rises over time. Withdrawal of equity by last-time sellers is much greater than injection by first-time sellers. Stock of debt naturally rises over time. If house prices are overvalued, those at the top have been removing more equity than they would have done in a less overvalued market, leaving behind on average more indebted households. If house prices are overvalued, those at the top have been removing more equity than they would have done in a less overvalued market, leaving behind on average more indebted households. Price bubbles are highly redistributive. Price bubbles are highly redistributive. Price bubbles are popular with voters, and politicians. Price bubbles are popular with voters, and politicians. Element of being a ‘Ponzi’ game. Element of being a ‘Ponzi’ game.

MEW is not the main story Savings and pensions are! State of the housing market, level of savings, and ‘pensions crisis’ are linked. State of the housing market, level of savings, and ‘pensions crisis’ are linked. Global liquidity story too. Global liquidity story too. If consumers believe that rapidly rising prices are sustainable…then they may believe that current consumption can be run at very much higher levels than in the past. If consumers believe that rapidly rising prices are sustainable…then they may believe that current consumption can be run at very much higher levels than in the past. Shocking evidence of unrealistic price expectations. Shocking evidence of unrealistic price expectations. (Case, K.E., Quigley, M., and Shiller, R.J. 2004) (Case, K.E., Quigley, M., and Shiller, R.J. 2004) Slack taken from other parts of the household balance sheet, and over-reliance on housing to generate future pensions provision. Slack taken from other parts of the household balance sheet, and over-reliance on housing to generate future pensions provision.

What about non-MEW… If many of those withdrawing housing equity are not immediately spending, what are non-MEW consumers doing to maintain consumption consistently at 96% or more of income? If many of those withdrawing housing equity are not immediately spending, what are non-MEW consumers doing to maintain consumption consistently at 96% or more of income? Low savings; Low savings; Eating into pensions contributions they ‘should’ be making; Eating into pensions contributions they ‘should’ be making; Non-MEW forms of debt; Non-MEW forms of debt; Relying on house prices? Some notion of ‘asset value allusion’. Housing wealth fungible with other forms of savings? The cheapest form of credit? Relying on house prices? Some notion of ‘asset value allusion’. Housing wealth fungible with other forms of savings? The cheapest form of credit?

Saving ratio Shows UK households’ saving ratio and house prices (plotted with negative of saving ratio) Paradox of thrift too in a major correction. Source: HMT 2004, Chart 6.3. p. 60. Source: Office for National Statistics and Office of the Deputy Prime Minister.

Saving ratio cont. Correlation between saving ratio and house price inflation one period earlier Source: HM Treasury, 2004, p64.

Impact of interest rates on house prices and consumption EITHER house prices are less volatile than in the past… EITHER house prices are less volatile than in the past… OR, if they are still just as volatile, the links to consumption are weaker… OR, if they are still just as volatile, the links to consumption are weaker… OR, interest rates can cope with any problems (ease cash-flow problems, cushion/slow house price falls, etc.) OR, interest rates can cope with any problems (ease cash-flow problems, cushion/slow house price falls, etc.) Direct and Indirect effects of interest rate changes via housing market: Direct and Indirect effects of interest rate changes via housing market: Both have forces working for and against. Both have forces working for and against. Both are difficult to be precise. Both are difficult to be precise.

Conclusions on direct and indirect effect The direct effect of reducing interest rates after the last house price crash was large. Likely more modest today. The direct effect of reducing interest rates after the last house price crash was large. Likely more modest today. The Bank of England should worry less this time when raising (or holding high) interest rates, but also feel less confident of the power of rate cuts to make a big impact on aggregate cash-flow. The Bank of England should worry less this time when raising (or holding high) interest rates, but also feel less confident of the power of rate cuts to make a big impact on aggregate cash-flow. Indirect effect stronger, but not much interest rates can do if large speculative aspect to house prices. Indirect effect stronger, but not much interest rates can do if large speculative aspect to house prices. But many caveats, including: But many caveats, including: Distribution and fragility of debt is not fully clear. Caution; Distribution and fragility of debt is not fully clear. Caution; Credit conditions generally; Credit conditions generally; Dangers of moral hazard if perceived to be ‘bailing out’. Dangers of moral hazard if perceived to be ‘bailing out’.

Redistribution effects of falling/rising house prices Rapid house price rises have similar consequences to sustained budget deficits, depressing the current real productive capital stock in exchange for current consumption by the gainers. Rapid house price rises have similar consequences to sustained budget deficits, depressing the current real productive capital stock in exchange for current consumption by the gainers. House price booms, just like government budget deficits, are popular with older consumers (and younger bubble-motivated consumer who ‘know no better’, or suffer asset price allusion). House price booms, just like government budget deficits, are popular with older consumers (and younger bubble-motivated consumer who ‘know no better’, or suffer asset price allusion). Like deficits, older consumers benefit from the ‘borrowing’ from future generations, even as long- term income levels are reduced due to the crowding out of real productive capital stock. Like deficits, older consumers benefit from the ‘borrowing’ from future generations, even as long- term income levels are reduced due to the crowding out of real productive capital stock.

Distributional issues suppressing long-run values Depressing influences on the investment potential of housing of the current generation (since the market for the value of their homes is the next, smaller, more burdened generation) include: Depressing influences on the investment potential of housing of the current generation (since the market for the value of their homes is the next, smaller, more burdened generation) include: demographically aging population; demographically aging population; falling cohorts in younger generations; falling cohorts in younger generations; record low savings; record low savings; deteriorating provision for retirement; deteriorating provision for retirement; the burden of social security and health increasing over time. the burden of social security and health increasing over time.

Rates of return… Given current valuations, the real rate of return on housing for, say, the next 20 years is much lower than the historical average of about 2.5% (indeed, zero is within the 95% confidence interval for the 20 year real rate of return). Given current valuations, the real rate of return on housing for, say, the next 20 years is much lower than the historical average of about 2.5% (indeed, zero is within the 95% confidence interval for the 20 year real rate of return). It also suggests that if correction is inevitable, it is not obvious that correction should be resisted. It also suggests that if correction is inevitable, it is not obvious that correction should be resisted.

Global House price correlations and global liquidity Highly synchronized positive movements in house prices, and global build up in mortgage debt. Highly synchronized positive movements in house prices, and global build up in mortgage debt. An extremely recent phenomenon that does not affect all countries equally: An extremely recent phenomenon that does not affect all countries equally: US, Australia, UK, China, France, Ireland, New Zealand, South Africa; US, Australia, UK, China, France, Ireland, New Zealand, South Africa; Relatively few EU countries. Relatively few EU countries. The correlation between real house prices and output (and consumption) has declined since the mid-1990s, reaching unprecedented low levels by 2003. The correlation between real house prices and output (and consumption) has declined since the mid-1990s, reaching unprecedented low levels by 2003. Potential for instability from outside UK Potential for instability from outside UK Hence issues of timing, interest rate decisions, etc. Hence issues of timing, interest rate decisions, etc.

Variance decomposition of house prices Source: IMF 2004, data from: Haver Analytics; IMF, International Financial Statistics; national sources; OECD; and IMF staff calculations.

UK case House Factor and Global Factor over time, per cent change, constant prices, demeaned Source: IMF 2004, data from: Haver Analytics; IMF, International Financial Statistics; national sources; OECD; and IMF staff calculations.

UK decomposition of house price change over time Orange = Actual Blue = Global Housing Factor Red = Global Factor Black = Country Factor Source: Extracted from IMF 2004

Global Liquidity Global driving forces – especially US house prices, US interest rates, and global liquidity. Global driving forces – especially US house prices, US interest rates, and global liquidity. 25% per year growth in the sum of America’s cash and banks’ reserves held at the Fed, and in the foreign reserve holdings of central banks around the world. 25% per year growth in the sum of America’s cash and banks’ reserves held at the Fed, and in the foreign reserve holdings of central banks around the world. Excess liquidity in the past flowed into traditional measures of inflation (goods and service prices). Excess liquidity in the past flowed into traditional measures of inflation (goods and service prices). Does extreme liquidity show up in asset price inflation – house prices – and record high global levels of debt, especially mortgage debt? Overreaction of housing markets after stock market crashes? Does extreme liquidity show up in asset price inflation – house prices – and record high global levels of debt, especially mortgage debt? Overreaction of housing markets after stock market crashes? US housing stock has risen in paper value by $5 trillion, almost precisely matching the $5trillion of lost stock market wealth of the early 2000s. US housing stock has risen in paper value by $5 trillion, almost precisely matching the $5trillion of lost stock market wealth of the early 2000s.

Did Global interest rates go too low? Natural rate of interest: the rate at which the supply of savings of households exactly balances the demand for funds by firms for investment purposes. Natural rate of interest: the rate at which the supply of savings of households exactly balances the demand for funds by firms for investment purposes. Natural rate is roughly equal to the rate of inflation plus the real trend rate of growth. Natural rate is roughly equal to the rate of inflation plus the real trend rate of growth. Natural rate moves about according to: Natural rate moves about according to: technological improvement; technological improvement; changes in preferences; changes in preferences; the impact of demographics on the need for savings, etc. the impact of demographics on the need for savings, etc. If cost of capital set below this, we get overcapitalization, excessive levels of borrowing and investment, saving too low, and the chances of bubbles greater. If cost of capital set below this, we get overcapitalization, excessive levels of borrowing and investment, saving too low, and the chances of bubbles greater.

Natural rate too low, continued For UK about 5% (2% inflation plus 2% to 3%). For UK about 5% (2% inflation plus 2% to 3%). Global natural rate (difficult to work out precisely) may even have risen (China, IT, global integration, inflation success, etc.). Global natural rate (difficult to work out precisely) may even have risen (China, IT, global integration, inflation success, etc.). Yet, some of these forces have also lowered inflation and even encouraged lower interest rates. Yet, some of these forces have also lowered inflation and even encouraged lower interest rates. And bubbles encourage households not to save, making things worse. And bubbles encourage households not to save, making things worse. Low rates followed collapse of late 1990s and various other crises/collapsing bubbles. Low rates followed collapse of late 1990s and various other crises/collapsing bubbles.

The US US (especially) interest rate kept below ‘natural rate’ for too long? 3% to 5% too low? Maybe after previous bubbles? Went from 6.5% in 2001 to 1% in 2003. US (especially) interest rate kept below ‘natural rate’ for too long? 3% to 5% too low? Maybe after previous bubbles? Went from 6.5% in 2001 to 1% in 2003. Past five years America’s national spending has exceeded its income by about a fifth. Past five years America’s national spending has exceeded its income by about a fifth. Private debt has boomed (nearly $10trillion). Private debt has boomed (nearly $10trillion). Savings have hit 0.5% (compared to historical average of 8%). Sometime, a reversion back to 8%? Savings have hit 0.5% (compared to historical average of 8%). Sometime, a reversion back to 8%? Private debt service is historically high – even before interest rates rise. Private debt service is historically high – even before interest rates rise.

US cont. US government has joined US citizens. Approx $450bn budget deficit per year. US government has joined US citizens. Approx $450bn budget deficit per year. Externally held portion of debt risen from 20% to 45%. Externally held portion of debt risen from 20% to 45%. Problems with ‘depth’ of US mortgage markets. Problems with ‘depth’ of US mortgage markets. Problems with US ‘lender of last resort’. Problems with US ‘lender of last resort’.

US cont. If a country has strongly favourable investment opportunities – that will ultimately make its inhabitants much better off – it is economically rational to consume some of the fruits now, borrow from the rest of the world, and repay from higher output later. If a country has strongly favourable investment opportunities – that will ultimately make its inhabitants much better off – it is economically rational to consume some of the fruits now, borrow from the rest of the world, and repay from higher output later. Meanwhile, run a strong currency and high trade and current account deficits that generate a net capital public and private consumption, rather than investment flow equal to the current account deficit. Meanwhile, run a strong currency and high trade and current account deficits that generate a net capital public and private consumption, rather than investment flow equal to the current account deficit. However, decomposition of US data shows that debt is currently largely being used to finance. However, decomposition of US data shows that debt is currently largely being used to finance.

Asia and US mutually reinforce Global foreign exchange reserves have doubled since the Asian crisis of 1998, to $3,800bn, with two-thirds of this in dollars. Asia accounts for 80% of this growth and now has 70% of global reserves. Global foreign exchange reserves have doubled since the Asian crisis of 1998, to $3,800bn, with two-thirds of this in dollars. Asia accounts for 80% of this growth and now has 70% of global reserves. Reserves account for 9% of global gross domestic product, compared to less than 2% during the pre-1971 Bretton Woods era. Reserves account for 9% of global gross domestic product, compared to less than 2% during the pre-1971 Bretton Woods era. High demand for US debt may be a response to previous crises. It has chipped 0.5% to 1% off US yields. It has helped the US to run large government and trade deficits. High demand for US debt may be a response to previous crises. It has chipped 0.5% to 1% off US yields. It has helped the US to run large government and trade deficits. China has chipped 0.1% to 0.3% of US inflation (maybe as much as 1%). China has chipped 0.1% to 0.3% of US inflation (maybe as much as 1%). In turn, China’s boom has been helped by low US rates. In turn, China’s boom has been helped by low US rates.

House price contagion? If sufficiently strong house price falls in one country (for example, rebalancing in the US will require lower spending on housing consumption) or several countries generate a decline in consumption for them, then it is more likely that consumption will fall in other countries too: If sufficiently strong house price falls in one country (for example, rebalancing in the US will require lower spending on housing consumption) or several countries generate a decline in consumption for them, then it is more likely that consumption will fall in other countries too: Real contagion (via consumption). Real contagion (via consumption). Financial contagion (via, in particular, mortgage bank and government balance sheets). Financial contagion (via, in particular, mortgage bank and government balance sheets). Equity-based bubbles less damaging than debt-based bubbles. Has mitigating the first, led to the latter? Equity-based bubbles less damaging than debt-based bubbles. Has mitigating the first, led to the latter? See Farlow, “UK House Prices, Consumption, and GDP in a Global Context,” Section 6, for scenarios. See Farlow, “UK House Prices, Consumption, and GDP in a Global Context,” Section 6, for scenarios.

Impact on UK policy How do these possibilities affect our attitude to falling house prices in the UK and central bank policy on interest rates? How do these possibilities affect our attitude to falling house prices in the UK and central bank policy on interest rates? If rebalancing of the UK housing market is inevitable, this suggests allowing rebalancing to proceed sooner rather than later – leaving the housing market in a better position to withstand global disturbances consequent on rebalancing elsewhere. If rebalancing of the UK housing market is inevitable, this suggests allowing rebalancing to proceed sooner rather than later – leaving the housing market in a better position to withstand global disturbances consequent on rebalancing elsewhere. Reversion to fundamentals, while it harms consumption, at least conceivably puts the economy back on a footing that emphasizes real economic activity over speculative housing activity and ends the distortions that lead to long-term pension and saving misallocation. Reversion to fundamentals, while it harms consumption, at least conceivably puts the economy back on a footing that emphasizes real economic activity over speculative housing activity and ends the distortions that lead to long-term pension and saving misallocation.

Lessons for the UK Global instability might matter more for UK house prices than is perhaps currently accepted. The fate of the UK housing market may currently be one of the less domestically controllable aspects of UK macroeconomics. Global instability might matter more for UK house prices than is perhaps currently accepted. The fate of the UK housing market may currently be one of the less domestically controllable aspects of UK macroeconomics. The Bank of England has faced an unenviable choice between trying to turn the tide of house prices and not sacrificing growth and risking under-hitting its inflation target. The Bank of England has faced an unenviable choice between trying to turn the tide of house prices and not sacrificing growth and risking under-hitting its inflation target. Emphasis on controlling the housing market has to include reforms and not just rely on interest rates. Emphasis on controlling the housing market has to include reforms and not just rely on interest rates.

Lessons for UK cont. Interest rates may have little power to influence house prices in a price collapse anyway. Trying to generate a cash-flow affect to offset a wealth effect caused by an unwinding bubble may simply not work very well. Interest rates may have little power to influence house prices in a price collapse anyway. Trying to generate a cash-flow affect to offset a wealth effect caused by an unwinding bubble may simply not work very well. Handling global surges in house prices might need more of a coordinated response than it probably gets, or is ever likely to get. Handling global surges in house prices might need more of a coordinated response than it probably gets, or is ever likely to get. Stop-go cycle via house prices in place of stop-go cycle via goods and services prices? Stop-go cycle via house prices in place of stop-go cycle via goods and services prices?

Asset price bubbles confuse inflation signals In fact recent asset price bubbles might have helped to dampen up-front inflationary pressures, and led to confusing signals. In case of equity market bubbles: In fact recent asset price bubbles might have helped to dampen up-front inflationary pressures, and led to confusing signals. In case of equity market bubbles: Artificially boost profits as measured in standard accountancy measures – firms adopt more aggressive pricing strategies; Artificially boost profits as measured in standard accountancy measures – firms adopt more aggressive pricing strategies; Positive feedback via capital accumulation and favourable supply-side developments, especially productivity gains, the spreading of technology, and ‘catch up’ in emerging economies (c.f. China), with consequent lower inflationary pressure; Positive feedback via capital accumulation and favourable supply-side developments, especially productivity gains, the spreading of technology, and ‘catch up’ in emerging economies (c.f. China), with consequent lower inflationary pressure; Firms able to make much lower contributions to pension schemes (and employees willingly accept, c.f. US 1990s); Firms able to make much lower contributions to pension schemes (and employees willingly accept, c.f. US 1990s); Employees tolerate less inflationary wage claims given perceived gains on stock market investments (especially evident in the US in the late 1990s); Employees tolerate less inflationary wage claims given perceived gains on stock market investments (especially evident in the US in the late 1990s);

Bubbles confuse signals, cont. Governments benefit from bubble-inflated asset prices that inflate the tax yield (stock market taxes at the end of the 1990s, housing transactions taxes, consumption taxes, low use of pension tax allowances, etc. in current housing bubble) and allow them to run lower tax rates than otherwise would be the case, even as their fiscal positions are strengthened; Governments benefit from bubble-inflated asset prices that inflate the tax yield (stock market taxes at the end of the 1990s, housing transactions taxes, consumption taxes, low use of pension tax allowances, etc. in current housing bubble) and allow them to run lower tax rates than otherwise would be the case, even as their fiscal positions are strengthened; When the bubbles unwind, all these things go into reverse – just at the wrong time. When the bubbles unwind, all these things go into reverse – just at the wrong time.

A public sector generated cash- flow shock? There are dangers in running a fiscal policy that risks a sudden tax increase in the face of a declining housing market (maybe at the same time as a swing in global credit conditions). There are dangers in running a fiscal policy that risks a sudden tax increase in the face of a declining housing market (maybe at the same time as a swing in global credit conditions). This time, the impact may show up more than usually as a public sector cash-flow problem. This time, the impact may show up more than usually as a public sector cash-flow problem. But burdens for the public sector are ultimately private sector burdens. It is simply an issue of timing. But burdens for the public sector are ultimately private sector burdens. It is simply an issue of timing. If house price falls are slow enough, this cash-flow problem can be offloaded to the private sector at a more timely pace. If house price falls are slow enough, this cash-flow problem can be offloaded to the private sector at a more timely pace.

Public sector cash-flow, cont. If price falls are more rapid (and confidence takes a greater hit) then the cash-flow difficulty (or even just expectations of it) may be fed much more quickly to the private sector – especially in the form of higher taxes – reinforcing the private sectors cash-flow problem and putting downward pressure on house prices. The economy finds itself on an even higher tax trajectory at quite the least opportune time for it. If price falls are more rapid (and confidence takes a greater hit) then the cash-flow difficulty (or even just expectations of it) may be fed much more quickly to the private sector – especially in the form of higher taxes – reinforcing the private sectors cash-flow problem and putting downward pressure on house prices. The economy finds itself on an even higher tax trajectory at quite the least opportune time for it. And tax rises are hard to target on the relatively less indebted (unlike interest rate falls). And tax rises are hard to target on the relatively less indebted (unlike interest rate falls). Growing tension between Bank of England and Treasury. Growing tension between Bank of England and Treasury.

Precarious balancing act for central banks If rates are raised too slowly, any momentum-driven bubbles will expand even further, financial imbalances intensify, with inflationary pressures built up for the longer term. Adjustment is simply delayed till a point when the fragility is even greater and when the dangers of triggering a switch to deflation are higher. If rates are raised too slowly, any momentum-driven bubbles will expand even further, financial imbalances intensify, with inflationary pressures built up for the longer term. Adjustment is simply delayed till a point when the fragility is even greater and when the dangers of triggering a switch to deflation are higher. If rates raised too quickly, fragilities may unwind too fast. If rates raised too quickly, fragilities may unwind too fast. Balancing act for debt holders too. Balancing act for debt holders too. This time real price falls will need nominal price falls. This time real price falls will need nominal price falls. This time the Bank of England would not allow the run- away inflation needed to create the negative real interest rates that would generate a similar situation today to that easing previous price collapses. This time the Bank of England would not allow the run- away inflation needed to create the negative real interest rates that would generate a similar situation today to that easing previous price collapses.

Central bank challenges, cont. Interest rates may have too much to do and be unable to fall as far as the housing market might require: Interest rates may have too much to do and be unable to fall as far as the housing market might require: If the pound were to weaken too quickly; If the pound were to weaken too quickly; OR oil or commodities prices rise too strongly, feeding UK inflationary pressures; OR oil or commodities prices rise too strongly, feeding UK inflationary pressures; OR the US were to suffer a fiscal crisis and sudden swing in sentiment forcing it to raise real interest rates much higher in defense; OR the US were to suffer a fiscal crisis and sudden swing in sentiment forcing it to raise real interest rates much higher in defense; OR UK government finances were to deteriorate quickly as lower confidence and economic activity reduced the tax yield. OR UK government finances were to deteriorate quickly as lower confidence and economic activity reduced the tax yield. Rising spreads may keep interest rates off the floor. Rising spreads may keep interest rates off the floor. System has not been stress-tested yet. Best to set so as to minimize the fall-out from mistakes. System has not been stress-tested yet. Best to set so as to minimize the fall-out from mistakes.

Central banks cont. Policy in the late 1990s settled on price stability via interest rate adjustments and not tax adjustment, since easier to set up an institution independent of elected government. Policy in the late 1990s settled on price stability via interest rate adjustments and not tax adjustment, since easier to set up an institution independent of elected government. Danger that governments rely on – even over-exploit – the policy credibility created by central banks. Danger that governments rely on – even over-exploit – the policy credibility created by central banks. A slow revision upwards of interest rate expectations is better than a sudden unexpected tax rise. Gradual reversions without surprises are best. A slow revision upwards of interest rate expectations is better than a sudden unexpected tax rise. Gradual reversions without surprises are best. Openness about interest rates – and at least the chance for households to think the scenarios through and factor higher interest rates in – contrasts sharply with the complete lack of openness about (and the political nature of) the timing and level of future tax rises. Openness about interest rates – and at least the chance for households to think the scenarios through and factor higher interest rates in – contrasts sharply with the complete lack of openness about (and the political nature of) the timing and level of future tax rises.

A Few Summary Thoughts Global rebalancing at some point. Global rebalancing at some point. Expected consumption and GDP response will matter. Expected consumption and GDP response will matter. Much of the analysis of the consumption response is based on efficiently operating bubble-free markets. Much of the analysis of the consumption response is based on efficiently operating bubble-free markets. Once we allow bubble mispricing, consumption responses are generally less well captured. Once we allow bubble mispricing, consumption responses are generally less well captured. Soft landing is not completely certain when a broad picture of consumption is considered, including pension and savings, and when levels as well as changes in levels are reviewed. Soft landing is not completely certain when a broad picture of consumption is considered, including pension and savings, and when levels as well as changes in levels are reviewed. Continued on next slide…

A few summary thoughts cont. Debt-backed housing price bubbles probably more damaging than stock market bubbles. Debt-backed housing price bubbles probably more damaging than stock market bubbles. The new stop-go cycle? The new stop-go cycle? Politicians love to exploit price bubbles. Politicians love to exploit price bubbles. Aftermath of current period likely to focus attention on a wide range of issues. Many of these require coordination across diverse economies, something usually achieved more easily in stable times. In less stable times, something much easier to handle if some thought has gone in ahead of time. Aftermath of current period likely to focus attention on a wide range of issues. Many of these require coordination across diverse economies, something usually achieved more easily in stable times. In less stable times, something much easier to handle if some thought has gone in ahead of time. Having better educated citizens helps. Caricature of ‘optimists’ or ‘doomsters’, ‘experts’ or ‘pundits’ does not help. Having better educated citizens helps. Caricature of ‘optimists’ or ‘doomsters’, ‘experts’ or ‘pundits’ does not help. THIS IS THE LAST SLIDE

Housing, consumption, and the economy: Why do house prices become misaligned, and what are the consequences? Andrew Farlow University of Oxford Department.

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Housing, consumption, and the economy: Why do house prices become misaligned, and what are the consequences? Andrew Farlow University of Oxford Department.

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Presentation on theme: "Housing, consumption, and the economy: Why do house prices become misaligned, and what are the consequences? Andrew Farlow University of Oxford Department."— Presentation transcript:

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