Britain’s housing market is dysfunctional. The rate of home ownership is plummeting, and the average age at which people become owner-occupiers is rising. In London and other property hotspots, the rents are unaffordable for those working at the sharp end of the service sector. Homelessness is on the up.

William Beveridge identified housing as a postwar challenge for Britain back in 1942 when he named squalor as one of the “giant evils” that barred the way to progress. Three-quarters of a century later, the giant still is alive and well.



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One curious thing about the housing market is that it is not really a market at all, at least not in the classic sense. As every student learns on their first day of economics, markets work through the law of supply and demand. Low prices act as a disincentive to produce but as prices rise so supply increases. Conversely, demand falls as prices rise because buyers consider products too expensive. There is a point where there is neither too little nor too much supply, but just the right amount to satisfy demand.

The world of real estate, however, is a million miles away from the textbooks. Economic theory suggests that homeowners would be encouraged to put their homes on the market when prices are rising, and that potential buyers would lose interest until prices start to fall.

This is not what tends to happen. Homeowners hold on to their homes because they assume that their property will continue to go up in price. Nor do rising prices dampen demand. Rather, people think they had better scramble on to the ladder before it is too late.

Policy decisions also matter. Britain is a small country with strict planning laws, which makes it harder for the supply of new homes to respond to rising demand than it would, for example, in the United States. The tax treatment of domestic property is generous, meanwhile, with no capital gains tax on prime residences and a ludicrously outdated council tax system.

The mismatch between supply and demand has been made worse still in recent years by the government’s help to buy scheme, whereby people can top up a 5% deposit on a new-build home with a 40% state loan in London and 20% elsewhere in the country.

The scheme has led to still higher prices without doing much to boost supply, but that didn’t stop Philip Hammond from announcing last week that he was putting another £10bn into it. This dwarfed the £2bn the prime minister announced for the building of new affordable homes.

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Help to buy exists because the combination of rising prices and stagnant wages has made life tougher for buyers. In 2002, the median house price in England was 5.11 times average earnings, according to the Office for National Statistics. The ratio had risen to 7.14 by the time the financial crisis put an end to the noughties property boom, after which it slipped back to 6.39 during the recession. It then started rising again and hit 7.72 last year. The trend has been even more marked in London, where the house price to earnings ratio rose from 6.9 to 12.88 between 2002 and 2016.

Those on the lowest incomes in London have fared worst of all. In 2016, someone among the bottom 25% of earners looking to buy a property in the cheapest 25% band would expected to pay 13.52 times their annual earnings. In 2002, the figure was 7.11.

These figures give rise to two questions. How has it been possible for house price increases to outpace wage rises to such an extent? And how are people managing to keep up the payments on the mortgages required for such expensive homes?



The answer to both questions is the same. The monetary stimulus provided by the Bank of England – ultra-low interest rates and quantitative easing – has put a rocket under prices, but slashed the cost of servicing a mortgage. Although the price of the average home in London has increased from £174,000 to £435,000 in the past 15 years, the fact that official interest rates have been 0.5% or lower for getting on for nine years has meant that the share of income spent on the mortgage has not risen. It has been a different story for those in the private rented sector, who pay almost twice the housing costs of those buying a home. It is estimated that a quarter of households who rent privately in London spend more than half of their income on rent.

Anyone who imagines that this state of affairs can continue indefinitely is kidding themselves. There comes a point when prices become so hot that buyers find their monthly payments too much of a stretch even with interest rates at rock bottom levels. The fizzling out of house price inflation during the course of 2017 suggests that moment has arrived.

There comes a point too when pressure starts to build for interest rates to rise. That moment is also upon us, with the Bank of England gearing up to tighten policy next month. In reality, the Bank’s freedom of movement is limited and it is inconceivable that interest rates will return to their pre-recession level of 5%, or anything like it, but the very high ratio of house prices to earnings means that even a modest increase in borrowing costs will reduce discretionary household spending at a time when it is already being squeezed. All that stands between Britain and a rip-roaring housing crash is Threadneedle Street’s willingness to spare borrowers from chunky increases in mortgage rates.

The alternative to yet another boom-bust is to try to construct a saner housing market. There are five steps to this. The first is to stop doing more harm through counter-productive policies such as help to buy. The second is to change the tax system, starting with council tax reform and action to prevent land hoarding. The third is to increase supply, and the housing expert Kate Barker has suggested ways the government could do so, such as identifying large sites abutting urban areas and acquiring them at a modest premium to the value of their existing use.

Step four is for the Bank of England to adopt a kid-glove approach to raising interest rates. The idea is to engineer a gradual fall in real – inflation-adjusted – house prices, not a recession that leads to a sharp increase in unemployment.

Step five is to find a way of boosting wages, because there are two ways in which houses can become more affordable. Earnings can rise or house prices can fall. The housing market will only become less dysfunctional when Britain becomes more productive.