Economics Coursework

Question 1: UK Housing Price Patterns

Interpretation of data

400,000 350,000 300,000 250,000 200,000 150,000 100,000

Mix-Adjusted House Price

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

London

UK excluding London

Fig. 1 shows the Mixed Adjusted house price for London and the rest of the UK between 2002 and 2011

Price Index (Base Year 2002)

140 135 130 125 120 115 110 105 100
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

% Change in Price (Year-to-Year)

30.0 20.0 10.0 0.0 -10.0 -20.0 -30.0
2003 2004 2005 2006 2007 2008 2009 2010 2011

London

UK excluding London

London

UK excluding London

Fig. 2 and 3 illustrate the increase in price and the year to year percentage change between 2002 and 2011

House prices in the UK have followed a similar pattern, increasing by over 35% between 2002 and 2007 and slowing down after that. However, prices in London have been consistently higher than in the rest of the UK with an average gap of 122,000 throughout 2002 2011. Investigating the year-to-year percentage change also shows that London prices have been more volatile from 2006 onwards with a standard deviation on returns of 11 compared to 7. To explain these patterns, we will use the supply and demand model and focus firstly on the 2002 2007 price increase. This will then lead to the discussion of the slow down and the differences between London and UK housing prices.

Supply-side consideration1 There is consensus supported by academic research (Meen, 2005, p963) and government reports (Barker Review 2006), that the housing supply in the UK was highly price inelastic over the last decade. The reasons behind this are still debated but two possible factors were the restriction of land supply and a lack of housing developments undertaken during the period. Tougher environmental laws, safety regulations (no construction on flood plains, unstable soil) and excessive restrictions from the planning system constraining the supply of land made available for development, increasing its price. At the same time, the fall in long-term real interest rates further raised the price of long duration assets such as land as investors viewed it as safe and profitable. The uncertainty associated with the lag time needed for permits and construction further reduced the marginal benefit of developing land such that overall, fewer than expected dwellings were built. As a result, despite the price rises, the UK housing stock increased at a rate bellow 1% for several years with only 175,000 new dwellings built in 20012. Demand-side considerations Since the supply of housing in the UK was inelastic, the substantial increase in average prices must be due to a succession of outwards shifts of aggregate demand caused by combination of demographic, macro-economic and behavioral factors. The increase in the size of the UK population3 has put some upward pressure on demand for housing because it has few good substitutes. Moreover, the low interest rate environment coupled with a loosened credit supply through easily available mortgages significantly increased the buying power of consumers for houses. These factors started a positive feedback cycle in which excess liquidity and expectations of future price rises further pushed up aggregate demand leading to a type of housing market bubble. Supply and Demand Model The arguments stated above are illustrated in Fig. x in which the inelastic supply causes the outwards shift of demand from D2002 to D2007 to be translated into a significant price increase from P2002 to P2001.
Price P2007 D2007 P2002 D2002 Q2002 Q2002
1

Fig.4 shows the supply and demand model for housing prices between 2002 and 2007.

Quantity

Source: What Determines the Responsiveness of Housing Supply, Discussion Paper No. 20, Eric J. Levin, Gwilym Pryce, Barker review of Housing Supply, Securing our future housing needs, Interim Report, 10 December 2003 According to the Office of National Statistics the UK population has increased by 3.1 million between 2001 and 2010

Department of Urban Studies University of Glasgow Glasgow,

2 3

Slow down after 2007 and price differences between London and the UK The subprime crisis and recession had an immediate effect on the UK housing market, which fell by 11% between 2007 and 2009. The reasons for this contrast with the previous boom: aggregate demand fell suddenly due to a shortage of credit and deteriorating confidence. The effect on prices was worsened by rising unemployment and excessive mortgage leverage, which caused many houses to be repossessed and sold at discounted prices, temporarily increasing supply on the market4.
Approvals for mortgages for house purchases

Fig 5 shows the steep fall in the mortgage supply in 2007 which correlates with the UK housing prices5 It is interesting to note that later movements of house prices and mortgages have followed a pattern similar to that of the UK economy, improving quickly in 2010 but slowing down as the debt crisis brings new uncertainty.

To conclude, we shall highlight reasons behind the persistent price gap between London and the rest of the UK. Planning restrictions such as the metropolitan green belt and strong economic growth have particularly limited the supply of residential land and housing in London. Adding to this is a high average earning level and a perceived desirability that attracts international buyers and investors in search of lower risk speculative assets. These factors amplify the supply and demand mechanism previously described and cause the housing market to be both more expensive and volatile in times of crisis.

4 5

BBC news: Home repossessions hit 14 year high (BBC News, 2011) Bank of England, Trends in lending, October 2011 publication

http://www.bankofengland.co.uk/publications/other/monetary/TrendsOctober11.pdf

Bibliography
BBC News. (2011, february 11). Home repossessions hit 14 year high. Retrieved november 15, 2011, from BBC News: http://news.bbc.co.uk/1/hi/business/8510077.stm Bank of England. (2011, october). Trends in Lending, October 2011 publication. Retrieved november 15, 2011, from http://www.bankofengland.co.uk/publications/other/monetary/TrendsOctober11.pdf Eric J Levin, G. P. (2009). What determines the reponsiveness of housing supply ? The role of real interest rates and cyclical asymmetries. University of Glasgow , Discussion paper No. 20. Paciorek, A. (2011). Essays on housing supply and house price volatility, PHD Thesis. University of Pennsylvania, Applied Economics. Scholarly commons. HM Treasury (2004). Barker Review of housing supply. Government review.