The next government will need to heed housing, if we're to avoid another financial crisis

The housing market has been an important part of the policy debates during the general election campaign. The central focus has been on the number of extra houses that each party plans on building, and the nature of the funding and support for these new houses. But as yet, there has been little discussion about how the housing market – and the suggested policies – will affect the wider economy, and effect that extra housing and funding will have on the welfare of the population.

There has been much said about the interaction between housing wealth (how much housing in total is worth to the economy), loans and economic stability. Given the crucial role of mortgages in the 2008 global financial crisis, these should be matters of great concern for all potential governments.

Lessons from the crisis

Many have argued that one of the main causes of the financial crisis was US legislation, which was enacted to encourage the main housing finance institutions to provide more mortgages to people who struggled to get them. This was known in the USA as the sub-prime sector. These people were basically borrowers who had a high chance of defaulting on the loan, and wouldn’t be offered mortgages under normal circumstances.

When interest rates were low and house prices were rising, there wasn’t a problem. But when interest rates increased, house prices began to fall, and much of the sub-prime sector struggled to meet the interest payments. As a result, many of the assets based on the sub-prime housing market fell dramatically in value, and so precipitated the financial crisis in 2008.

There are many lessons from this crisis, but above all it is clear that the housing market and its associated financing play a key role in the stability of an economy. It also suggests that excessive intervention in the housing market is potentially dangerous, and that any sizeable intervention needs to be accompanied by careful monitoring.

Influencing the economy

A number of studies, have found a strong link between the housing market and the economy as a whole, especially with regard to levels of consumption. In general, as house prices (and therefore housing wealth) increases, so does consumer confidence and access to loans. This in turn leads to increases in consumption. But the relationship is not quite this straightforward: for instance, there is evidence that a rise in house prices leads to an increase in consumption, but when house prices fall, there isn’t an equivalent fall in consumption.

Higher house prices leads, in a roundabout way, to higher inflation.from www.shutterstock.com

Another concern is that increasing house prices can indirectly lead to inflation, through the increase in demand brought about by rising housing wealth. Essentially, if house prices rise, individuals feel more wealthy, and so increase their consumption of goods and services. This increases demand for those goods, which in turn increases their prices and leads to a rise in inflation. As a result, housing wealth is an important consideration for the Bank of England, when it is determining the interest rate. Whether or not central banks should react to changes in house prices, and potentially change interest rates as a result of excessive movements in them, is the topic of much debate.

Housing bubbles

Another feature of housing, is that like other asset markets, it is liable to forming speculative bubbles, where house prices rise sharply above the fundamental value of the house. Arguably, this occurred before the financial crisis, and the collapse of the bubble in the UK added to the economic problems then experienced by the UK economy. Of course, it is not just central banks that need to keenly observe house price movements: governments also need to monitor them. This is partially because they can use fiscal policy, such as taxation, to control house prices. But it is also because of the important social implications of homelessness and inadequate housing.

The housing market also has a role to play in the regulation of the financial system, if, for instance, the authorities decide to set limits on the amounts of mortgages with respect to household income. Since the financial crisis, there has been a move towards what is termed “macroprudential policy”. This means that the central bank monitors the financial sector as a whole, rather than institution by institution. This could include monitoring total mortgage debt, house price changes, levels of speculation in the housing market and levels of home ownership.

Although this is mainly the responsibility of the regulator, it is also important for any government: it is governments that need to produce the necessary legislation to control the financial system, where required. Another important question involves the success (or otherwise) of policy instruments. For example, would possible caps on loan‑to‑value ratios, have any influence on household gearing, credit growth or house prices? Although we are still in the early stages of developing macroprudential policy, it will be an important consideration for all future governments.

Bruce Morley does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.