MichaelCD - The Blog.

The thoughts of Michael Cadwallader. Coffee loving, history book reading, Cheshire man.

Saturday, November 25, 2006

Attack of the Mind Fog

I read David Smith’s economics UK blog regularly. For those of you who aren't aware of him, David is an author, and the Economics editor for the Sunday Times. And, his blog is a very informative read.

David fulfils a useful purpose for me. As most of the things I don’t understand about economics send me into blind panic, a read of David’s blog usually returns me to acquiescence. Take the M4 money supply. It's out of control, I think. Surely inflation is gonna rocket! And, the pound is gonna going to go down the pan! Not true, says David:
What's changed is that inflation on all measures has come in lower than expected, earnings growth remains very benign and the Bank has published an inflation report showing a quicker return to target than it previously expected. M4 growth does not represent a dilution of the pound sterling, in fact it is hard to tell what it is. There's a nice chart in the Bank's inflation report (1.6 p12) showing the poor relationship between M4 and money GDP.
Everytime I read his blog, the alchemy that is modern finance, looks more and more like an exact science. It’s entirely explainable, predictable and, well, goldilocksish. I wonder why I am so sceptical of this 'new economy'. Look at the alchemy involved with Gordon Brown’s mismanagement of the economy. Think of him smelting discarded copper ingots, some iron-ore, and some moon dust to finish it off. And then he brings the metal out of the forge - and it looks a lot like gold. All hail the modern-day Paracelsus, say the media. Unsurprisingly, this leads me to feel mighty confused and unsure about all things economic. Is there really nothing to worry about, I think. So what do I do? I read David’s blog, try to understand what on earth he is talking about, and if I have understood, I tend to rest a lot easier.

However, that feeling evades me when I think about the UK housing market. To be brutally honest, it baffles me. And, no matter what they do or say, economists, like David, still can’t convince me that there is not more to it than supply and demand. Take this BBC article, where they have even provided graphs, and a veritable collection of these supply and demanders. And as I read it, that fog didn’t clear. Infact, I was left in the middle of a mind-peasouper.
There are currently 22.8 million households in Great Britain. The Department for Communities & Local Government (DCLG) predicts that another million or so will be added in the next five years alone.

And by 2016 there will be 25.1 million households in Britain - an increase of 2.3 million in just ten years. A lot of attention has been given to the fact that the country has seen a surge in immigration recently, principally from Eastern Europe.

But Professor Michael Ball, of the University of Reading business school, said the rise in household numbers will be driven by a large increase in the number of us who are living alone.
No, no, no, it’s nothing to do with immigration. It never is to the BBC. So, what else can we find to explain it? Ah yes, single ownership households. Let's beat that drum mercilessly:
We estimate that the number of households has been growing at 200,000 or even more each year in recent years," said Milan Katri, chief economist of the Royal Institution of Chartered Surveyors.

Yet new building has been running at between 140,000 and 160,000 a year, he added.

Thanks to successive government policies, hardly any new council houses have been built for the last 20 years. Some people who might once have rented have been more or less forced to buy instead.

Tony Key, Professor of real estate economics at the Cass Business school in London, said this under supply of housing has led to a huge distortion in the UK property market. Somewhere around the mid 1980s we stopped building council houses and we didn't fill in the gap. There's been a group of people who might logically be renters who have been forced into being owner occupiers," said Professor Key.

Meanwhile millions of former council homes have also been sold by local authorities.
I wrote about both of these, in the spring. Undoubtedly, single ownership households have had a major impact on the housing market. But this has been happening for years, as the BBC graph shows. Therefore, they didn’t stop the housing prices from crashing in the early 90s. So, yes BBC, immigration has been widely mentioned as a price-driver, and with very good reason too.

But there is still something missing, with regards to the housing market. Single households cannot explain everything. A Professor, called Christine Whitehead, has another explanation:
Despite our perennial complaints about the roguishness of estate agents, dilatoriness of lawyers and the cost of stamp duty, buying and selling here is relatively easy to do.

Professor Whitehead said our transaction costs are lower then in most of rest of Europe, where taxation and the administrative costs of moving can take more than 10% of a property's value. We have a much more fluid market, in the main, buying and selling does not take very long, she said.

If you add in the fact that we have lots of houses -which offer more privacy and control than flats, a legal system geared to the home owner and the fact that mortgage repayments are usually cheaper than rent, then you have some pretty good reasons to buy a house.
Perhaps this is the nub of the matter. Instead of, as the BBC report wrongly states, being a nation of ‘homeowners’, we are now a nation of ‘housing speculators’. We're not after a home, but an 'investment'. After all, all those aforementioned single households have to be able to repay a mortgage by themselves. So, with only one wage, and with wages fairly stagnant, how on earth is all this possible? The most plausible explanation is that it’s mortgage providers, who seem hell bent on a race to the bottom, with regards to lending practices. Their motto is lend, lend, lend. Interest only? Yes sir, sign here. Bad credit rating? Who cares!

And then I think of the logical conclusion to all speculation. What happens when we reach the lending bottom of the barrel? And how long can we afford these 'mega-mortgages', on stagnant wages. Well, David Miles from Morgan Stanley, believes that as much as half the growth in house prices since 1996, has been down to speculation. And he predicts there will almost certainly be a slump, maybe within the next two years.

And this is where David Smith comes in again. As I am thinking speculation, leveraging and hyper-growth. It sounds an awful lot like a house of cards. Now I am really worried! But David actually admonishes this thinking:

The effect of rising population and limited housing supply on prices should not be underestimated. The number of new “dwellings” being completed is rising. I use the word dwellings advisedly because about half of current “housing” starts are flats and maisonettes. The House Builders Federation has just changed its name to the Home Builders Federation for that reason. In 2004-5, 206,750 dwellings were completed, nearly 9% up on the previous year. But housebuilding has not moved decisively higher. During the 1990s, the typical number of new dwellings completed was about 190,000. Nearly 90% of new accommodation these days is built by the private sector.[...]

Housing demand is not, of course, just about population growth and immigration. It is also affected by size of household, divorce, how early young people fly from the parental nest, second homes and a range of other factors. The government’s projections show that in England alone there will be an average of 209,000 new households annually over the next two decades.

The strength of housing demand is one thing, but what about the “fact” that house prices are plainly too high? The surprise about this year’s housing market strength is that what looked like an overvalued asset has gone up a lot more. How can this be, and how dangerous is it? Perhaps not at all, because housing was not overvalued.

I read it and all the worry should have been smoothed away. It's the goldilocks housing market! I shouldn’t still be thinking ‘house of cards’. And yet, this doesn’t look like alchemy. It’s plain to see, at least to me, that at this level, housing is in an unsustainable boom. So I am still puzzled. And I am still panicing. I remember that I am not an economist, David Smith, Saxon Brettell, professors Ball, Key and Whitehead are. They know what they’re talking about; they have the degrees to prove it. What do I have? A couple of economic textbooks, that I don't really understand.

Losing interest in the subject, and with my head hurting, my mind drifts to something I do know a lot about - energy. I remember the oil price going up and up earlier in the year. And, I remember my words at the time:
My belief is that the rises in energy prices are permanent. So does Stephen Leeb. It's simple supply and demand, and thanks to our Chinese friends, there is not enough to go around.
Hmmm, they sound very much like the economists quotes. It's Supply and demand due to single households. It's supply demand due to Chinese consumption. In fact, what I said at the time was mostly true. Oil prices remain historically high. The fundamentals are driving the oil price. And the supply and demand situation is a major factor behind this. But it’s all very easy to underestimate speculation when the prices are rocketing, especially when you have fundamentals on your side. That was a lesson I learned the hard way.

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At 5:03 pm, Anonymous Anonymous said...

I'm the same when it comes to economics. When it's put simply, I can deal with it. Jargon about inflations and supply and redirectional tapungerical jugandgpobery just makes my brain hurt.

I'm hoping for a housing slump, or at least a dramatic fall in prices over the next three years or so. I know it's bad for me to say so, as it will probably have consequences that I'm too stupid to understand, but I do so badly want to move out of my dad's house as soon as I can, to live with friends if necessary. If prices remain as they are, I, and many of my age, will have little hope.

Thanks, Michael, for raising my hopes with another greatly insightful post.

At 11:55 pm, Blogger nzconservative said...

A lot of my opinions on economics are just common sense instincts, and no doubt often wrong. I also feel more comfortable thinking about trade and resource issues rather than the abstract finiancial stuff.

I tend to hedge my bets by striking a balance between trusting common sense and trusting the experts, and staying away from the most abstract issues.

I reckon a number of economists are underestimating the impact resource price increases are going to have though, because most economists aren't literate in other disciplines.

Economists seem to think that cheap power will always come from somewere but I have big doubts about this - look at the opposition to nuclear power for example. If something is deeply ingrained then only a very serious event like a major war or recession will change people's minds.

On the topic of house prices-

House prices down-under have never gone down because every time the market faulters the government simply increases immigration.

The danger of a housing crash in the UK is greater because you can't use that option to the same extent, given that Britain is already very crowded.

A crash is probably less likely than it was in 1991, but I wouldn't trust an economist that dismissed it out of hand.


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