Aug 022013

[This is a bit more opinionated and political than I would normally post, but I think it’s important. I don’t care which party runs the country as long as it’s run fairly and honestly, according to logic, reason and evidence. Unfortunately that sounds hopelessly naïve. This contents of this post are hardly controversial, but it’s just a part of my small attempt at giving people a greater understanding of the world and enabling them to spot when others aren’t acting according to honesty, reason and evidence.]

I really don’t understand the logic of the Government’s Help to Buy scheme.

In the first part of the scheme, buyers of new homes only need a 5% deposit and can borrow a further 20% of the value of the house from the Government. This portion of the loan is interest-free for five years, after which fees are applied. The homebuyer then only needs to find a 75% mortgage. This can only do damage in the long run. Let’s look at an example:

The normal situation

Alice has a good job. With her deposit and mortgage she has £160,000 to spend on a house. Bob has a reasonable job, and he can spend £140,000 on a house. Chris can only afford to buy a house for £120,000. Two identical new houses have been built – what happens?

In a scarce market where there isn’t enough supply to go around, the price is set at the margin of availability. Bob is going to get a house, and Chris isn’t. Therefore the houses will be sold to Alice and Bob for somewhere between £120,000-140,000. (With a larger example there would be more people willing to pay £121k, £122k etc, so the price would be more finely defined.)

The end result is that two of the three people own a home, and paid not more than £140,000. The Government sees this and thinks it can do better, because Chris still doesn’t have a home. Seeing that Chris was only just priced out of the market (the houses go for slightly more than he can borrow), they decide to offer an extra loan to Chris so he can now afford the £140,000. Let’s see what happens:

With help to buy

Chris gets the additional loan of £30,000 so he can now afford to pay £150,000. Alice can still afford a house. Bob, however, is now set to miss out, so he also takes an extra loan of just over £10,000. Both houses sell to Alice and Bob for just over £150,000.

Then end result is that Alice and Bob still own houses and Chris still doesn’t, but houses now cost at least £150,000. This is obvious from the beginning – if you have two houses and three buyers, only two people can successfully buy, no matter how the money is distributed.

Maybe the problem is actually that there aren’t enough houses? It’s a bold claim, I know. Let’s see what happens:

Building more houses

Assume that these houses cost £120,000 to build. By building one more house, Chris could pay £120,000 and the house builder would still make £20,000 profit. The end result is that Alice, Bob and Chris all have houses, and they paid at most £120,000 for them.

An aside: where does the money go?

House prices are much higher compared to wages than they used to be 10+ years ago. So what is the money paying for? House building is a competitive business and there is no shortage of labourers looking for work, so it’s unlikely that house building are making large profits. And indeed, the construction sector has been struggling recently.

The bottleneck in the housing supply is land for development, due to our strict planning laws. While building a house doesn’t cost a huge amount more than it used to, buying the land does. The increase in cheap mortgage lending by banks enabled this boom in land prices last decade, because people with more money are able to spend more to outbid others for scarce resources (i.e. land for housing).

When you sell a house you realise the increase in the value of your land, but you spend it again on your new house so you’re no better off. Follow this through and it’s apparent that any increase in the money supply to buy new houses goes straight into the pockets of the landowners who sold the land. None of it stays with homeowners or builders.

Part two of the scheme

The potential damage from part one of the Help to Buy scheme is limited by the fact that it only applies to new builds. The price can’t be pushed up too far because you can always buy a cheaper old house instead, for which the money supply hasn’t increased. However, this is set to change.

In January 2014 the mortgage guarantee part of the scheme will launch. In this scheme, buyers will only need a 5% deposit to get a mortgage. Banks like large deposits because in the event of a default, repossession and auction, the sale will bring in more than the outstanding debt. With a small deposit there is a danger that the bank may lose out, so with this scheme the Government guarantees 15% of the mortgage, thus enabling banks to offer ‘safe’ (from their point of view) loans to people with tiny deposits.

What this will do is increase the money supply available to buy all houses, not just new builds. There are still the same number of houses, and there will be even more buyers competing for them than currently. An exercise for the reader: repeat my first example in this case and work out what will happen.

If you said that prices are likely to increase across the board, and no more people will get a house than would have done before (except that they’ll pay more for them), well done.

The wider point

Most of the population have (understandably) very little knowledge or care about economic principles. That shouldn’t be a problem because we should be able to trust that the people making economic policy do understand. Unfortunately it seems that governments exploit this lack of knowledge to pass policy that is actively damaging to the economy but serves political ends. If you can’t afford a home and suddenly you’re offered a cheap extra loan, you’re likely to be pleased and support the policy, even though it’s nonsensical to all economists.

In another example, austerity was heavily sold as being vital for maintaining the UK’s AAA credit rating. We were told that reducing the deficit makes lenders less likely to think that we’ll default, therefore maintaining the AAA rating, therefore keeping interest rates on UK bonds low. This is deliberate misinformation – nobody cares what the credit agencies think (after all they gave AAA ratings to all the subprime mortgage packages that caused the crisis in the first place), and a low risk of default isn’t the primary reason why bonds are cheap. It’s a small part, but the main reason is that our economy has been doing so badly, with such a slow recovery, that even getting a measly 2% for ten years is more attractive than investing the money elsewhere in the economy.

My hope is that we eventually get a critical mass of people, both in the general public and the media, who have a reasonable understanding of economic principles and statistics. Governments will no longer be able to get away with easily-refutable claims, dodgy statistical usage and illogical policies. Only then will we get governance based on what is best for the people of the country, and not damaging policies purely designed to  win votes.

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