A revealing dinner party conversation on house prices.
Dinner Party Bore: The people next door have just sold their house. Ours must be worth at least twice what we paid for it!
Dinner Party Host: Only twice what you paid for it! We could sell ours, buy a mansion in Cornwall, and still have enough to cruise round the world five times.
Another Boring Guest: But prices are bound to crash. Everyone says so.
Former city economist, now employed as waiter: If you don’t mind my interrupting, I wouldn’t believe anything commentators say. They don’t know. And even if they did, they aren’t disinterested – they want you to buy, or sell, or just attract your attention. People who predict house prices are no more credible than people who predict share prices. Believe me, I used to be one.
Guest: But the ratio of house prices to household incomes is at an all time high!
Economist: But there is a mistaken analogy here between the price-earnings ratio for houses and the price-earnings ratio for shares. The stock market multiple usually reverts to its long run trend. That’s why – I realise now – shares were overvalued in 2000.
Guest: That would have been useful to know! But surely people can’t spend an ever increasing proportion of their incomes on housing, any more than they can spend an ever increasing proportion of their incomes buying pet food on the internet.
Economist That’s insightful: if I’d understood it earlier, I might still have a job. But you are right to focus on the costs of house ownership rather than the cost of houses. Interest rates have fallen so much that a typical mortgage payment is lower than it was ten years ago.
Host: So you think prices could rise further! Perhaps we could buy a chateau on the Loire as well as a mansion in Cornwall, darling.
Economist Not so fast! Interest rates were high when inflation was high, so even if the initial cost of a mortgage seemed crippling, people could expect the burden to become easier. And mortgage repayments are only a small part of the cost of buying a house: you have to pay for repairs and maintenance, heat and light, property taxes.
Host: So the people in your old firm who used to get huge bonuses must be feeling the pinch.
Economist: Some of them are. The economist Fred Hirsch wrote about positional goods – commodities in limited supply would always be owned by the richest people. Trophy wives, for example, like your lovely spouse. Houses are the archetypal positional good. Competition for them means that the distribution of house prices will more or less reflect the distribution of incomes. With increasing income inequality over the last twenty years, prices of the most desirable houses have risen faster than those of simple homes. That trend could easily be reversed.
Host: Maybe you’d better start looking for our country property right away, my dear! But why are Cornish house prices so much cheaper ?
Economist: Supply and demand. Land near capital cities is scarce, so its price is correspondingly high. And population has moved from rural to urban areas. The value of your Cornish mansion will be less than its rebuilding cost. If it didn’t already exist, no one would build such a property now.
Guest: So you think this talk of a house price bubble is overdone?
Economist: Somewhat. In classic bubbles – from tulip mania to the dot.com frenzy – people bought things, not for their intrinsic worth, but to sell on to others at a higher price. That rarely happens with houses.
Guest: So why does the housing market keep having booms and busts?
Economist: Because of tittle tattle like this. When people think that prices will rise, they jump into the market: if they fear prices may fall, they are quicker to sell. As in every asset market, short term price movements are driven by beliefs, not underlying realities.
Guest: So what do you really think is going to happen?
Economist: I used to say on the one hand, then on the other hand, but now only when I’m doing silver service. Short term expectations of a price fall will probably be self validating. But who knows what will happen in the long run. The one thing I can tell you is the people who pontificate about these things don’t know any more about it than you.
Host: And that’s why it’s time for you to use both hands for the washing