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House Prices
Alan Hutchinson
Smashwords edition 17 April 2015
Copyright © Alan Hutchinson 2015
In southern England, and probably elsewhere too, homes cost so much that most families have difficulty paying for one. It is usual to buy a house with a debt so large that it changes the course of the buyer's future life. This is not good.
The great recession was brought about by debt. It became well known when banks themselves, the big lenders, were trapped in debts. Many of these banks' debts were owed to other banks, but perhaps the biggest root cause was the debt of small people who borrowed money to buy houses where they could live. They borrowed too much.
How did this situation come about? How can it be improved?
This note presents a few different ways by which houses might be bought, and discusses their consequences.
Suppose that nobody borrows money to buy a home. If there are three eager buyers and three houses for sale, and if all three buyers have the same preferences for the houses, then the buyer who is able and willing to spend most money will buy the nicest house. The one with second largest pot of available money will buy the second nicest, and the one with least will buy the third house if he can afford it. If he can't afford it then he will have to rent, or go into lodgings, or live with friends and family, and the last house won't be sold.
Let us suppose that there is what is called an efficient market for houses: everyone knows how much others are willing and able to pay (though not who the other potential buyers are). For the sake of argument, suppose too that most buyers are not desperate to buy, but sellers usually need to sell. Then the most attractive house will be sold for just a bit more than the second richest buyer is able and willing to pay. The next most attractive will be sold for just a bit more than the poorest buyer could pay for it. Unless the seller of the third house is really desperate, that house may not be sold.
Next, suppose the same as in Scenario 1 except that each buyer can borrow some extra money. A bank or building society is able and willing to lend any potential buyer as much as the buyer himself has already. Thus, each buyer can spend just twice what he could spend in Scenario 1.
The outcome will be similar to that in Scenario 1: the most affluent buyer gets the nicest house and the second gets the second nicest house. The third may perhaps get the third house. Perhaps the third is more likely to have a house to live in than in Scenario 1, but otherwise their domestic arrangements are not changed.
The main difference is that the bank or building society is better off, and the house sellers have more money, and the buyers are left with large debts.
For the bank, this is a big improvement. Banks survive by just such lending events. The house sellers are probably not much better off because they will probably want to buy other houses, so the extra money they have gained will just go to pay the extra for the houses they in turn want to buy, similarly. The buyers of these three houses will remain in debt for perhaps 10 years. They will be obliged to stay in paid work for all that time, whereas in Scenario 1 they might have been free to work just enough to eat and stay warm.
By the way, some employers will be happier, because their employees are more vulnerable and so probably more docile: they dare not make a fuss for better pay and conditions for fear of losing their jobs and their homes.
In this third case, suppose everything is as in Scenario 2 except that the bank can lend much more, perhaps ten times a buyer's pot of cash. The outcome will be just as in Scenario 2 except that the bank is even happier and the buyers have to borrow even more to compete with other buyers. In practice, this will probably mean each borrows five or ten times his ready cash. The sellers who still need homes have to pay for them maybe ten times what they would in Scenario 1, so some of them may also be worse off.
In this scenario, any buyer who does not start with almost all the cash needed to buy a nice home will end up with a debt he will be unable to pay for most or even all his working life. He will be a wage slave for ever. Less sympathetic employers will be delighted.
When pundits discuss house prices, they usually suggest that the way to make houses cheaper is to build more houses. They cite the so-called law of supply and demand: a commodity is cheaper when there is more of it.
In the case of houses, this seems to be misleading. We are not short of houses (though in some areas we are short of nice houses near where people want or need to live). House prices are so high because of a different instance of the law of supply and demand. There is a lot of money available to buy them with. Money is plentiful whereas houses are less so, and so a seller can demand a lot of money for his house.
Money itself is a commodity, just like houses or cars or cheese. We trade it every day for the other things we want. Usually, we express the value of a house in terms of the amount of money needed to buy it on the open market; but one could equally well describe the value of a hundred thousand pounds (or dollars) by describing the nicest house one could buy for that price.
Creating more houses makes each house cost less money. Creating more money makes each hundred thousand pounds buy less house.
What is money? Who creates it?
First answer: money is what you keep in your pocket, the stuff which you use to buy food and newspapers in shops. It comes out of ATMs (holes in walls) when you put in your bank card and press a few buttons. In England it is made by an institution called the Royal Mint. Actually, I am not even sure that is true. On its web site, the Royal Mint says it makes coins. An ATM does not supply coins – it supplies bank notes. I don't know who makes them.
Second answer: Money is controlled, and sometimes created, by the Central Bank. In the UK, that is the Bank Of England. In the USA, it is the Federal Reserve Bank (the FED). One of its main duties is to control commercial banks. By Law, it can instruct each commercial bank only to lend or borrow money under certain conditions, such as
how much money or other liquid assets each other bank must keep, in case the people it has borrowed money from want it back suddenly
how much money each other bank must lend to the central bank.
Third answer: money is what is counted within the computers of commercial banks.
This answer may seem silly. What is the point of counting something if the only way of describing it is that it is counted? Nevertheless, that is what it is. If the bank tells you that you have so many pounds in your account, then that is what you have.
Since each commercial bank controls its own computers, each such bank can make more money just by altering the numbers in those computers. It is only constrained by the laws administered by the central bank. When it lends to a buyer who wants to buy a house, it just increases the number in the buyer's account. It will probably decrease another number somewhere else, to keep everything legal; but creating new money inside the bank is that easy.
This new money which banks create as loans is almost never manifested physically. When the borrower spends it to buy a house, the borrowed money is subtracted from the borrower's account and the same number is added to the seller's account. The seller's account may be with the same bank, in which case no physical money ever moves at all. If the seller's account is with another bank then the borrower's bank will owe that much money to the seller's bank; but still no physical money moves between them. There are many such transfers, and they almost always almost cancel each other out. Any slight imbalance just appears as a debt between the banks themselves.
Most money is created thus, by increasing the number in a borrower's account with a bank.
The amount which a commercial bank lends is typically about 25 times the sum it could in principle raise if it sold all its so-called liquid assets – shares, bonds, and so forth. In practice, if a bank really tried to raise all that money quickly then it couldn't do it. Just by trying to sell so many shares and bonds, a large bank would cause panic in the markets for shares and bonds. The law of supply and demand would apply again to prices of shares and bonds, and their prices would fall. This is why such banks are said to be too big to fail.
This seems to be the current state:
House prices are high because it is possible to borrow a lot of money in order to buy a house.
Banks benefit from lending to people buying houses. Such people pay interest on their debts. Most such people can also be relied on to repay their debts. The few who don't repay will lose their houses, and the banks can sell them and so regain most of the debt that way.
Owners of houses also benefit from high prices, but not as much as one might imagine because if an owner sells his home then usually he has to buy another.
Employers benefit because employees with large debts are likely to be docile.
On the other hand
A large proportion of the population is in debt, so is frightened.
Such fear inhibits initiative. The nation, Britain or the USA or wherever, is likely to lose much of its innate creativity because all those in debt dare not take risks with their jobs.
Such fear is a cause of stress, which in turn damages health.
Therefore, lowering house prices by restricting loans would seem a good idea. Lending by banks to people who want to buy a house should be constrained. However, if such lending were constrained suddenly, and house prices fell quickly, then
those who have already bought houses with large debts will be worse off than ever. Their one escape path, selling their homes, would not raise enough cash to pay off the debts. They would have negative equity.
Those who bought a home with a large debt, and have repaid it believing that they can live out retirement on the wealth invested in that home, will be poor and aggrieved.
A lot of the banks' so-called liquid assets consist of the debts lent to house owners. Whenever the prices of such houses fall, so do the banks' assets. The big banks are already more precarious than most of us like to believe, and such a fall in their assets could well cause another crash like that of 2008.
Unwinding the debt spiral will be a long complex process. The most that the average house buyer can do is avoid entering it. Try to avoid debt.