Save your Money With 100% Percent Remortgage

Avoid Boom and Bust in Housing Market

The past two decades have seen two spectacular boom and busts in the UK Housing Market. Whenever there is a bust, it is hard to imagine that we could return to yet another period of spectacular house price growth. But, with housing supply falling woefully short of government targets for population growth; there is every chance of another housing boom. - perhaps not for another 2-4 years; but, it could definitely happen again.

The costs of allowing housing boom and busts are too great, there needs to be effective policies to moderate unsustainable booms in lending, house price growth and the consequent adjustments this causes.

What Should Government Do?

1. Change Monetary Policy

At the moment, monetary policy is primarily targeted at the control of inflation and stable economic growth. If the MPC were given two targets inflation and avoiding asset bubbles, then maybe we could avoid booms in the Housing market. i.e. they would raise interest rates if house price growth was too high. However, there are problems with this.

* It is hard to target two things at once. During 2004-07 House price growth was frequently over 20% a year, but, CPI inflation was averaging 2.7%. To reduce house price growth would have caused a painful decline in output. It could even have caused a premature recession; the MPC would have been widely criticised for causing unemployment just to prevent house prices rise.
* Interest rate increases would have had to be very high.
* Difficulties of Knowing why House prices are rising. It is difficult to know when house price growth is a consequence of excess lending / speculation and when it is due to economic fundamentals of demand greater than supply

As Charles Bean (deputy governor of MPC of Bank of England), commented in a recent speech on 22 Nov 2008 :

“It is simply not credible to believe that the UK house-price boom that is now unwinding would never have happened if only the Bank’s Monetary Policy Committee had set official interest rates just a little bit higher. “

Banks were really keen to lend, and I doubt slightly higher interest rates would have discouraged many homeowners from taking out mortgages. - It is similar to the fact that cuts in interest rates have failed to stimulate the housing market.

2) Regulation of Banks.

One policy suggested by Anil Kashyap, Jeremy Stein and Raghuram Rajan [1], is to get banks to purchase private capital insurance from a suitable ‘deep pocket’, such as a sovereign wealth fund, that pays out if aggregate financial conditions deteriorate sufficiently. The idea is in boom conditions to make banks save more and reduce the growth in their credit lending. Then in a bust, the banks can rely on their own private insurance schemes to meet shortfalls - rather than rely on government bailouts. This scheme is not aimed at reducing overall bank lending. But, making bank lending less cyclical and volatile. It would mean less 125% mortgages in the boom years. But, it would also avoid some of the freezing of mortgage markets we see at the moment.

3) Spanish Example

In Spain, banks are required to build up a general reserve equal to the difference between an estimate of long-term losses and specific provisions on currently impaired assets. It is noteworthy that Spanish banks have largely avoided the credit crunch. Abbey owned by Spanish group Santander have been one of the few banks to lend more. (Though Spanish house prices still rose too much and are now falling)

Traditionally the idea of government regulation of banks is dismissed by free market economists. They argue that it will reduce investment and anyway banks can get round the regulation.

However, these are not good reasons.

4) Increase Supply of Housing

Whilst there is a shortage of housing, the scope for rapidly rising house prices always remains. However, in the US, the supply of housing increased in response to the boom, but, the massive homebuilding didn’t prevent the boom. (in fact many houses were still coming onto the market at the end of the boom - when it was too late.) this shows that addressing supply issues will not on its own solve the propensity to a credit boom and bust.

Also, of course, the UK is notoriously bad at meeting targets for building new houses. Everybody agrees new houses should be built - just as long as they are not anywhere near where they live.

Conclusion

We cannot rely on monetary policy to prevent house price volatility. The MPC should be free to target inflation and output directly, without trying to solve micro economic housing problems as well.

Nor can we leave this issue to the dynamics of the free market. The consequences of housing boom and busts are too painful for the economy. It will not be easy to regulate the banks; but since they have been humbled and forced to come begging to the government, we will never have a better chance to force them to take responsible steps to moderate boom and busts in credit / mortgages.

[1] See Anil Kashyap, Jeremy Stein and Raghuram Rajan, ‘Rethinking Capital Regulation ‘, presented at
Federal Reserve Bank of Kansas City Symposium on Maintaining Stability in a Changing Financial
System, 2008.

This article was taken from the Mortgage Guide blog