How government housing schemes (and the Bank) push up house prices

As house prices remain high, and the average age to buy your first house gets higher, government schemes to help individuals and families get on the housing ladder are popular.

The coalition has recently launched 2 new schemes – First Buy and New Buy, in addition to other schemes already running, such as Home Buy. (If you’re confused, you’re not alone – there’s still more schemes out there!). Both are helping low-incomes home hunters by helping with deposits, although the details vary. Both schemes are also a boon for house builders, who must be pleased with their lobbying, since these schemes favour new builds over existing houses. All those unsold flats are eating into their profit margins…

However, all such schemes to help, regardless of the mechanics of the scheme, are part of the problem. Let’s look at the basics…

Imagine there are 1 million people looking to purchase a home, and able to get a mortgage. This represents the demand for house purchases. (Remember that demand from an economic point of view means the individual has the means to pay for what is desired, and not simply the desire for a good or service). When a new government scheme is passed, this figure increases to 1.1 million. There is now more money chasing the same number of houses, so inevitably prices rise. If by some amazing coincidence, all house hunters had the exact same budget, then prices on aggregate would rise by about 10%. In reality, the price rise would vary by region and property type. (This is why we have to be very careful with aggregation, one of the many pitfalls of Keynesian economics. The nationwide average house price may not rise at all, but the house prices of the types of property involved in the scheme might have risen significantly.)

Schemes such as New Buy might appear to help, as only new build homes qualify.   Yet as noted above, house builders are keen to unload stock that has struggled to sell in the recession, so new supply isn’t going to meet the new demand. In any case, across the alphabet soup of schemes, the primary focus is to quality more people for mortgages, not increasing the supply of homes.

It’s also worth remembering many of these schemes lend money to borrowers who were too risky for banks to lend to. As a result, there is an increased likelihood of default and foreclosure – a major feature of the American post-bubble crash.

As economists (should) point out, none of the above says that we shouldn’t do such schemes (though I would agree!), but we must be aware of the costs in doing so. Pretending these schemes only have benefits helps nobody.

Ending these schemes would help to lower house prices, but there is a far bigger problem out there, and the masthead of the blog might give you a clue. Unsurprisingly, house prices are very sensitive to interest rates, and as interest rates were lowered across the Western world in the 2000s, house prices shot up. The Bank of England, the Federal Reserve, and the European Central Bank all lowered interest rates significantly, setting off another business cycle, as explained in previous posts on the Austrian theory: here, here, here and here. Whereas the housing schemes I’ve discussed affect perhaps a few hundred thousand people at maximum, lowering interest rates affects many more. As affordability improves as rates decrease, the demand for housing soars, and house prices follow. For those who aren’t convinced by the theory, the data from the last decade clearly backs this up.

This problem makes it very hard to tell how much real supply and demand issues are causing high house prices, and how much is just all the new money flowing from Threadneedle Street. Here in the UK we do have a growing population, and there is certainly a perception that we need to build a lot more houses to cope. This low supply and high demand is almost certainly true, but without proper prices, it is very hard to understand just to what degree the problem exists. In any industry, prices need to match reality so that consumers and producers match their behaviour to suit – perhaps by producing more or consuming less. It’s instructive to remember that not only does nobody tell farmers how many crops to plant, but neither which crops to plant. Prices match supply and demand for each good in the marketplace. There have been countless flats built in recent years, but consumers might be demanding more detached houses – these potential mismatches are just as important as the overall number of houses being built.

Before we can attempt to solve the problems in the housing market, we need to have an accurate understanding of them – so that’s yet another reason to abolish the Bank of England. Otherwise we’re prescribing medication without a diagnosis.

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2 Responses to How government housing schemes (and the Bank) push up house prices

  1. nomasir says:

    Andy – love it as always. I’m always amused when politicians declare a need to “make [insert good or service here] more affordable” – and then institute policies that drive up the price, making it LESS affordable. Brilliant.

    • andyfrith2 says:

      I guess we shouldn’t be surprised – politicians understanding of economics is usually pretty poor, and the stated aims of the policies are often no poor than a cover story. In this context, the house builders are getting a massive tax-funded subsidy, but the policy is sold to the electorate on the basis of making homes more affordable. When will they finally learn the laws of supply and demand??

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