Housing Market, BREXIT and the Economy

Anupam Koul – H00141413

School of Energy, Geoscience, Infrastructure and Society – Heriot Watt University, Dubai Campus

Abstract: This paper examines the macroeconomic variables that determine house prices and based
on an understanding of these determinants evaluates how the housing market in the UK has been
influenced by these determinants over the past four decades. Using literature studies and empirical
data on economic growth and house prices, the paper gains an understanding of the
interdependence between the two. While there are very clear interdependencies, it is found that the
house pricing in UK is also influenced by other factors, such as planning regulations, which at certain
times have had a more robust impact on house prices than the macroeconomic variables. In the
second part, the paper reviews predictions for macroeconomic data and based on the
understanding gained in the first part of the paper, forecasts the trend that house pricing is
expected to follow in 2017.

1. Introduction – Macroeconomic determinants & house prices

The international banking crisis of 2007, triggered by the collapse of mortgage finance market in
the USA has increased interest in the function of the housing market as related to the
macroeconomic variabilities and how in turn the macroeconomic variables impact the housing
economics. There is evidence to suggest that the housing market plays an important role in the
macro economy and also the performance of the economy could affect the housing market (Wei &
Morley, 2012). Ahearne et al (2005) found that significant falls in house prices have often been
accompanied by macroeconomic downturns and “have at times contributed to financial distress”.
Rising house prices directly contribute to the macro economy in terms of increased consumption as
a result of increasing asset wealth of the households, allow for a larger collateral against credit
from banks, thus improving their ability to consume products and also impacts the financial
markets in terms of advanced mortgage backed derivative products.

2. Literature Review

The effect that various macroeconomic variables have on the house pricing has been the subject of
various studies and research papers. As noted above this subject has become of particular interest
since most central banks traditionally steer away from framing monetary policy based on property
cycles. Indeed, for most central banks, targets for asset prices are not mandated objectives for
monetary policy (Ahearne et al, 2005). On the other hand, Mishkin (2007) recognizes the central
role that the housing market plays in the economy and states, “To achieve the dual goals of
promoting price stability and maximum sustainable employment, monetary policy makers must

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understand the role that housing plays in the monetary transmission mechanism if they are to
appropriately set policy instruments”. Gabriel et al (2009) argue that the disastrous consequences
of the housing crisis of 2008 mandates a thorough evaluation of housing policy and regulations.
Since the credit crunch of 2008 there is an increasing recognition of the need for monetary policy to
address asset prices, in addition to goods prices (Blanchard et al, 2010).

In terms of the macroeconomic indicators impacting house pricing, literature survey indicates wide
ranging opinions on which of the macroeconomic indicators has the most effect on housing cycles.
While it is generally recognized that some of the macroeconomic indicators have a direct bearing
on housing prices, there are other factors such as planning regulations and demographics that are
seen to have a significant effect. In addition, it is quite difficult to evaluate how much the price
changes in housing are being led by macroeconomic factors as opposed to other factors such as
“irrational exuberance” (Ahearne et al, 2005).

McDonald & Stokes (2011) conclude that house prices are greatly impacted by interest rates and
one of the main reasons for the financial crash of 2008 was the excessively low nominal interest
rates in the period leading up to the crash. The extremely easy credit terms including very high
mortgage approval rates led to large scale defaults and foreclosures that undermined the asset
backed securities being traded in the financial markets (Khandani, Lo and Merton, 2009). Galati,
Teppa and Alessie (2011) have argued that empirical data suggests that in addition to the
macroeconomic factors, house prices are driven by institutional/geographical factors and locally
available funding arrangements. Xu & Tang (2014) quoting Adam & Roland (2009) state that
“economic activities are mixed components of real GDP and they find that real consumption, real
industrial production and employment are closely related to house prices in the long run”. However,
Zhang, Zhua & Zao (2011) in their study of the housing determinants of macroeconomic policy in
the Chinese context, have quoted Negro & Otrok (2007) to state that while there is sufficient
literature on the interactions between monetary policy and house prices, there seems to be a
dearth of studies on specific impacts of monetary policy on house prices. They further conclude
that monetary policy and price variables are the only two macroeconomic variables with a direct
impact on housing prices while other variables such as economic growth, industrial production and
international trade have only an explanatory power for housing trends.

3. Determinants of House Prices

The literature study carried out in the previous section has highlighted that there exists a broad
range of opinions on the actual impact that macroeconomic variables have on housing dynamics.
Nevertheless, a strong body of literature suggests a strong and direct impact of various

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macroeconomic variables such as economic activity, interest rates, monetary policy, inflation,
employment, credit and money supply. In this section we undertake a brief explanation of each of
these variables and the manner they are deemed to influence house pricing trends.

a. Economic Activity (GDP)

An increase in economic activity through growth in industrial production results in a
demand for additional space. Since construction response is typically delayed, there is a
short term increase in rent leading to higher house prices. Ahearne et al (2005) in their
research of 18 industrialized countries, concluded that typically the real GDP growth
remains robust during the periods leading up to the peak in house prices and begins to drop
markedly in the quarter leading to the peak.
b. Inflation
Rising costs of construction materials and increased labor costs have a direct bearing on
house prices and result in tightening of margins for developers which are invariably passed
on to consumers. The higher construction costs lead to a decrease in construction and thus
to a lower level of housing stock (Adams & Fuss, 2010). The resulting decrease in available
housing space impacts rental prices and leads to appreciation in house prices. Ahearne et al
(2005) have shown that inflation begins to pick up a quarter before the peak in house prices
and continues to grow even after there has been a downturn in house prices.
c. Interest Rates
Adams & Fuss (2010) have argued that the impact of short term interest rates on house
prices is difficult to determine since higher short term rates could impact the house prices in
both ways. Higher short term interest rates would depress the demand for housing due to
higher mortgage rates while house prices could also move in the other direction due to a
decrease in construction activity resulting from higher cost of borrowing for the developers.
The effect of long term interest rates on the other hand negatively affects house prices in
terms of depressing housing demand due to higher costs of mortgage and shifting available
capital into other investment vehicles such as bonds.
d. Unemployment
The unemployment rate is an indicator of the state of the economy and reflects the
uncertainties inherent in the macroeconomic climate. Higher rates of unemployment
decrease consumption of goods and services, lower wage growth and depress growth in the
economy. Barksenius and Rundell (2012) have found a negative correlation between the
unemployment rate and house prices and have concluded that unemployment rates
generally remain low during the rising phase of the property cycle but tend to increase

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 during downturns. This would suggest that fall in house prices resulting in lower
construction activity might itself be a determinant of unemployment, especially in countries
where construction activity forms a large part of the economic activity.
e. Demographics
While demographics and population growths are not considered macroeconomic
determinants, these can have a significant impact on the house price trends in many
countries. Even so, there are several studies which have tended to discount the direct
impact of demographic trends on house prices. Adams & Fuss (2010) have concluded, based
on several papers on the subject such as Manikew & Weil (1989), Berg (1996) and Hort
(1998), that population changes have an insignificant impact on house prices. However
recent empirical data suggests that this is not the case and changes in demographics can
have significant impact on demand for housing. Jones (2012) has found that the relatively
quick stabilization of house prices in the UK post credit crunch of 2008 can be explained by
the inherent dynamics of the UK housing market where historically housing supply has failed
to keep pace with rising demand due to immigration and population growth. Ahearne et al
(2005) state that rising house prices in several countries such as Ireland, Australia, UK and
the US have been accompanied by growths in working age populations. Conversely, the
decline of populations in Japan and Germany have had a bearing on the depressed property
markets over a period where the rest of the industrialized world has witnessed housing
booms.

4. Housing market in the UK

Over the past three decades the housing sector in the United Kingdoms has experienced an
unprecedented growth in value with empirical data indicating that in the last 20 years property
values in the UK have doubled while over the past 40 years, property values have increased by a
factor of 40 (Niemietz K, 2012). This phenomenal growth cannot be explained by standard
macronomic determinants of house prices since similar economies in Europe and North America do
not exhibit similar behavior even when macroeconomic variables are similar over the same period.
In terms of macroeconomic indicators such as monetary policy, interest rates, GDP growth and
unemployment, UK exhibits parameters similar to other developed economies where GDP growth
has been on an upward trend, unemployment has been falling, monetary policy has been easing
and interest rates have been at all-time lows since the credit crunch of 2008. Nevertheless,
property markets in USA, Spain and Ireland, which experienced property booms since after mid to
late 1990s are yet to recover from the depths experienced in the immediate fall out of the
recession in 2008 and generally reverted to their mid 1990 levels. On the other hand, prices in the

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UK remain comfortably at levels seen in mid 2000s and are projected to improve over the next few
years (Niemietz, K. 2012, PWC, Housing Market Outlook, 2016). The UK housing market is also
unique in that a high percentage of assets are owned by occupiers with the owner occupier
percentage being as high as 70% in 2011. In comparison this figure for France and Germany stood
at 56% and 45% respectively (Xu & Tang 2014).

However, it would be too simplistic to state that house prices in the UK are only driven by variables
particular to the UK and that other macroeconomic factors have negligible or no effect on housing
prices. A review of various macroeconomic factors in comparison to the course of house prices in
UK since 1980s is given in the following figures 1 to 4.

As noted previously in this paper, UK has generally witnessed an upwards trajectory for house
prices over the past 4 decades. The growth is marked by two bubbles in the late eighties and later
part of the previous decade, culminating in the credit crunch of 2008. Xu and Tang (2014) note that
in both instances, it was the easing of mortgage finance and banking regulations that had caused
the bubbles. The peak of 2007 particularly saw a sharp increase in property prices from the rather
deep troughs of mid-nineties. While the post credit crunch scenario has led to a fall in the prices,
these have recovered somewhat and are back to the early 2000s levels.

Figure 1: House Prices and GDP - UK. Data: Office for National Statistics

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The UK has enjoyed a rather stable growth in the economic output since the early eighties,
following on from the large scale de-regulation of the banking industry. One the other hand, during
the same period the housing market witnessed a boom – bust - boom cycle. This would seem to
indicate that neither the fall or rise of the property market had a significant impact on GDP growth.
Converlsly, it would appear that the downturn in property prices in early nineties continued in spite
of a steady growth in the economic output.

Figure 2: House Prices and Interest Rates. Data: Bank of England

From the heady days of late seventies and early eighties, interest rates have been on a downward
trajectory, except for the boom period of early nineties when the BOE had to increase the rates to
tackle inflationary pressures on the economy. Following the credit crunch of 2008, most central
banks were forced to slash interest rates in order to stimulate the collapsing banking industry. As
can be seen from figure 2, periods of high interest rates are accompanied by lower house prices,
with the prices rising as interest rates ease off. As has been discussed earlier in the paper, lower
interest rates impact the house prices in terms of lowers mortgage costs and lower costs of
borrowing for developers.

The unemployment data for the past three decades shows a remarkable relationship with the
course of house prices – high rates of employment coinciding with lower property prices and vice
versa. Generally, the peaks and troughs in the employment data precede those of the house pricing

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pointing to a relationship between the two. Lower unemployment levels increase the capability to
consume products and services and generate a demand for more space for housing.

Figure 3: House Prices and Unemployment. Data: Office for National Statistics.

It has been argued earlier in this paper that while not being a macroeconomic determinant,
demographics and population growths can have a significant impact on house prices, although
there are several studies and papers that have discounted the argument. The following figure 4
seems to support these papers and seems to indicate that cycles of housing market are not
impacted by the demographics. The population growth in the UK has been pretty steady since
1980s except for showing a slight quickening at the beginning of the last decade. Nevertheless,
there is also statistical evidence to the fact that over the past several decades, supply of housing
has not matched the demand for housing space (Jones, C. 2012). has presented the view that do
not have any bearing on the discount such a possibility. Niemietz (2012) has strongly suggested that
the significant increases in housing prices in UK are due to stringent planning regulations that have
suppressed housing supply. The anomaly could be explained by the fact that most papers suggest
that the gap between demand and supply of housing units is existing for a long time going as far
back as the boom periods following the second world war while the presented data only goes back
to 1980.

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Figure 4: House prices and Population Growths. Data : Office for National Statsitics

Jones (2012) further reports that the level of house building in UK in 2010 was at the lowest since
1924.

5. BREXIT and Housing market in the UK

The decision of the British public to leave the European union has had a significant bearing on
business sentiment and in cases has translated into actual impact to industry performance. It was a
wildly held belief by the leave camp that the decision to leave the EU would massively disrupt all of
the macroeconomic indicators and could lead to a long period of depressive tendencies in the
business environment. While there is still some time for UK to actually exit the union, it has been
more than 4 months since the vote and the doomsday predictions haven’t really materialized.
Several of the macroeconomic indicators continue to show robustness. The unemployment rate is
quite low and still showing a downward trend, interest rates are still low and inflation does not
show any signs of getting out of hand. Economic output is increasing albeit at a slow rate and
property prices in UK have fared much better than similar economies around the world. The
behavior of the house pricing trends in UK, since the 2008 credit crunch, indicates that there is a
demand for housing in the country which is not likely to be satisfied without a significant increase
in supply. Even with uncertainties associated with Brexit fallout on immigration and demographic
trends, the house prices seem unlikely to reverse their upwards course at this particular time or in
the near future. This hypothesis is further supported by several papers that have studied the
macroeconomic determinants of house pricing in the aftermath of the credit crunch and have

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concluded that the stronger than expected showing of the UK property market indicates different
drivers for less than expected drops in property prices in the immediate aftermath of the credit
crunch and better than expected recovery in house prices in the last couple of years. As such, it
would seem very likely that if all the macroeconomic indicators continue their present trends, the
house prices in 2017 will see continued growth, although this is likely to be tempered by the
uncertainty from outcomes of Brexit negotiations.

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