How much higher can house prices go?
Official data released last week on London house price increases in 2016 generated a lot of interest. Given that housing represents by far the most important component of wealth for most people, it is not surprising that stories like this are read avidly.
There is a feeling that the current situation regarding the affordability of housing, or rather the lack of it, is without precedent. This seems to be the case if we look at, say, the Halifax House Price Index, the UK’s longest running monthly house price series. But this only goes back to 1983.
A very thorough and impressive study of house prices going back to 1870 has just been published in the American Economic Review. Katharina Knoll and other German economists have gathered an immense amount of primary source data to produce series for house prices for nearly 150 years in 14 developed economies, including both the UK and the US. The authors strip out the general level of inflation, so their series show how house prices have changed in terms of affordability. Their work extends in time and space a path-breaking paper by MIT’s Matthew Rognlie, which came out in 2015.
There are two striking features of the data, which are common across all 14 countries examined. From the late 19th century to the middle of the 20th century, house prices in real terms were effectively flat. There were fluctuations during this period, but overall, houses were more or less just as affordable in 1950 as they had been in the decades before the First World War.
Since then, house prices have risen considerably faster in all countries than prices in general. In most countries, the trend has been accelerating. As the authors put it: “in the final decades of the 20th century, house price growth outpaced income growth by a substantial margin”.
Knoll and her colleagues go on to analyse why this has been the case, bringing together estimates of both the cost of construction and land prices. They find that about 80 per cent of the total increase in real house prices in advanced economies since 1950 is due to higher land prices.
Almost incredibly, the great English economist David Ricardo predicted in the early 19th century that this would happen in the long run. In practical terms we might, for example, be able to increase the supply of land in the short term by relaxing green belt regulations. But, eventually, the inherent scarcity of land will resurrect itself and prices will rise in a growing economy.
The results also have important implications for the ongoing debate about inequalities in wealth. Most of the rise in the inequality of wealth which has taken place in recent decades is due to the housing market, which in turn is driven by land prices.
Thomas Piketty generated a commotion with his book Capital in the 21st Century, which essentially argued that wealth inequality was driven by the greed of capitalists. Detailed empirical work by economists such as Knoll and Rognlie refute this view decisively.