“Compounding is one of the most powerful forces in the universe” is a popular maxim that springs to mind when thinking of the UK’s housing market.
On standard housing valuation metrics, such as average house price to average income, housing is again at its most expensive on record. Since 1980, the compounded inflation-adjusted gain for a UK homeowner has been 212 per cent. Before 1980 house price gains were much tamer over the various cycles either side of the second world war. Indeed, in aggregate, prices were largely unchanged over the previous 100 years, once inflation is accounted for.
Understanding, diagnosing and reversing this trend is critical for the cohesiveness of UK society. High house prices are one of the factors causing one of the great divides in society today: that is between the haves and the have nots; between the older property-owning generation and the younger renters (who are unable to get on to the property ladder). It is also part of the explanation as to why UK productivity growth rates have collapsed in recent years to close to zero.
The question, though, is why has this happened? The answer may well surprise the reader.
Popular political and media narrative suggests that it relates to high immigration and a lack of housing supply. Other explanations focus on the rapid increase in ownership of second homes by UK households or the high number of overseas buyers. Others look at increased affordability as more women have entered the workforce.
None of those factors, either on their own or together, though, could have accounted for the significant step change in real terms house price growth (from the early 1980s onwards). Indeed UK population growth for the past 40 years has been at or below long-run averages; home building has been running above the rate of population growth through to 2005, albeit the high divorce rates of earlier decades soaked up much of that earlier overbuild; while UK households own, for non-investment purposes, only 382,000 second (holiday) homes, that is 1.2 per cent of the housing stock (with the increase/flow each year equating to only 0.08 per cent of the total stock), according to government data. These explanations alone neither fit the 1980 step change narrative nor are significant enough to generate persistent real house price gains over a prolonged period of time.
There is a business model in housebuilding that relies on constantly rising land values
The one factor that did change, though, and marked the start of that step change in 1980, is the supply of mortgage debt. The change in supply dynamics of mortgage debt, brought about by a number of waves of financial deregulation starting with Margaret Thatcher’s government in 1979, has resulted in a sevenfold increase in inflation-adjusted mortgage debt levels since then.
That process has been aided and abetted by two other factors: first a fiat money international monetary system, in place since 1971, which has facilitated the build-up of large country imbalances and money creation. Second an inflation-targeting central bank, which has delivered a more aggressive monetary response to each of the recent downturns, because of that high debt burden.
At its heart, though, the supply of mortgage debt has been driven by three rounds of the international Basel accords. At each round, mortgage debt has been deemed to be increasingly less risky. In Basel 1 in 1992, 50 per cent risk weightings were applied to mortgages. In Basel II, agreed in 2004, that was reduced to 35 per cent. Basel II then added a further twist, introducing an option for banks to calculate their own internal risk weightings.
In Basel III, those standard mortgage weightings are expected to fall again. With the use of those own internal calculations, UK large bank mortgage risk weightings are running at around 12 per cent of notional loan value. Banks therefore now require substantially less capital than would have been required before Basel I and one-eighth of the capital required versus a corporate loan.
Successive Basel accords have therefore incentivised banks to rapidly increase mortgage debt in the UK economy. That supply of mortgage debt is the real key reason for the step change in the rate of increase of UK house prices from 1980.
It is also the key driver of the build-up of household indebtedness and the debt supercycle and goes a long way to explaining the poor productivity growth, rising income inequality and the gap between the haves and the have nots. It’s also not just a UK phenomenon. Basel is a worldwide accord.
Chris Watling is the chief executive officer and chief market strategist at Longview Economics
This article has been amended. 382,000 second (holiday) homes represents 1.2 per cent and not the original published figure of 0.08 per cent of the housing stock.
