How House Prices Fuel Wage Rises

One of the great puzzles of the UK economy is why, despite massive increases in unemployment, an apparent transformation of the industrial relations scene and an environment of global disinflation, wage inflation remains so high.

Our recent research(*) on wages finds the housing market to be centrally implicated in the inflationary process; I suspect that the housing market is as important as the deficiencies of the UK's labour market institutions and its system of training and education in explaining the country's relatively poor post-war economic performance. We now appear again to have embarked on a spiral of domestic inflation in which house prices feed wages and wages feed house prices. Worries about the exchange rate in the inflationary process have been exaggerated.

There are three chief mechanisms by which house prices affect wage settlements. First, house prices are an actual or prospective elements of the cost of living for those buying or about to buy a house, even if this is not reflected in the Retail Price Index. Second and perhaps even more important is the effect on house prices on labour mobility. When house prices rise, those in the more prosperous areas lead. This makes it more expensive for those in less prosperous areas to move and increases the mis-match between unemployed people and unfilled job vacancies. Lastly, it may be that house price inflation in excess of retail price inflation is a cause of increased inflationary expectations. It could also conceivably be merely a symptom, in which case conclusions drawn here are overstated.

We have built upon the well-known Layard-Nickell real wage model for annual data to provide the empirical evidence. Included in Stephen Nickell's latest version of this model, the real new house price of two years ago and a regional house price difference both weighted by the proportion of owner occupiers, shows both effects to be strong and stable over time.

According to our estimates, the forces that pushed up real house prices and regional differentials in the last three years have added, or will add, about 4 per cent to real wages and, because of feedbacks, much more than that to nominal wage inflation into 1986. Preliminary work with quarterly data confirms an average lag of two years, though some of the effects occur in the first year.

To explain why house prices are not an ingredient in the wage equations of any of the major macromodels, I suggest first the surprisingly long lag of their effect; second, the rapid feedback from earnings to house prices, demonstrated by the econometrician David Hendry, makes confusion between lagging house prices and earnings easy; third, wage equations have not usually included the theoretical sophistications of Layard-Nickell, and finally, in the past, with a lower proportion of owner-occupiers, house prices were less important.

Probably the single most important reason for recent rapid house price increases has been the disappearance in about 1981 of mortgage interest rationing. The housing market may be the major channel by which the money supply influences inflation directly rather than via interest rates. If this is so, it is ironic that, at the very time the monetarist cure for inflation was being most strongly implemented, the mechanisms effectively to control mortgage credit were being dismantled.

More fundamentally, there can be no doubt of the central role in house price inflation of mortgage interest tax relief, which has helped to guarantee real rates of return that, over the years, have overshadowed those on other assets. Given the effect of house prices feeding back into earnings, there was a potential tinderbox which again and again threatened to ignite. In the past, the lid was kept on by mortgage rationing, incomes policy and sometimes by high interest rates. In the 1980s, the lid had been high interest rates and increasing unemployment.

Let us consider the correct policy response. It should not be deflation through higher interest rates. The conventional view is that raising interest rates slows inflation by strengthening sterling, thus reducing import costs and cutting demand for goods. To these must be added the effect via the housing market. However, our empirical research reveals significant offsets. First, cutbacks in production, which reduce labour utilisation, increase unit costs and prices. Second, sudden shocks, whether positive or negative, result in additional hiring or firing costs and these get passed on to prices. All three are reasons to avoid Stop-Go macroeconomic policies.

There are other , more long-term limitations on the effectiveness of deflation, whether policy-induced or not.

Deflation eventually reduces the effective supply of labour and of productive capacity so that, when demand picks up, inflationary pressure is more likely.

The political arguments against higher interest rates and higher unemployment are even stronger than they were. Given the Government's commitment to wider share ownership, it could be disastrous for electoral prospects if in the next few months, interest rates have to be jacked up, producing capital loses for many new investors and reducing the cash flows of owner-occupiers.

Instead, the correct policy response should begin with the urgent repetition of the recent warning on mortgage lending by the Governor of the Bank of England. But the fundamental aim must be to re-set the tax signals which are at the core of the problems of house price inflation, now much exacerbated by the continuing liberalisation of housing finance. Capital gains tax could be extended to main residences and the "Schedule A" tax on imputed rent reintroduced. A good economic case can be made for these. Simper would be the announcement of a phased withdrawal, over three years perhaps of mortgage interest tax relief with a politically advisable compensating reduction in the standard rate of income tax. The opposition parties would no doubt incorporate egalitarian elements in such a reform. But it seems virtually certain that if the basic element of this proposal were adopted by the Government, they would swiftly include similar proposals in their platforms.

Consider the consequences if such a package succeeded over the next year or two in rolling back the average level of nominal house prices to, say, that prevailing in 1984-85. It would impart a major deflationary impulse to the UK economy but one bearing largely on prices, rather than activity.

Wage inflation would fall, lower interest rates would be possible, not only because of the reduction in inflation but because of reduced levels of credit demand. Consumer borrowing, base don housing collateral, which is destined to increase further with the new freedoms of building societies, would fall or grow more slowly bringing down the growth in monetary aggregates and in the volume of imported consumer goods.

House and land prices would fall by more than the average in London and the South-East where the speculative excess has been greatest. This would improve the conditions for regional mobility, make the labour market more efficient and reduce a source of inflationary pressure. An additional benefit would be that the rental market in housing would become relatively more attractive and better supplied. Moreover, conditions of falling house prices provide the ideal moment to reform legislation in the rented sector. Reform in the past has been stifled by the rent increases that would have resulted from liberalisation.

Who loses and who gains? The paper capital losses of owner occupiers are obvious but, for many, cash flows would improve. Those with holdings of gilts and equities would benefit from the appreciation made possible by falling interest rates. New buyers should benefit greatly and, since as an age group, many have been battered by unemployment, high interest rates and high house prices, that seems fair. The worst affected would be incautious lenders to the housing market; their capital time as does their interest income.

There are two other policy options facing the Government. One is the re-introduction of mortgage rationing but this now looks feasible. The other is an incomes policy of the Layard type that would operate through taxes on companies and which I favour as an additional weapon in the campaign against inflation.

Optimists will argue that basic reform is unnecessary: there are indications that house price increases are slowing; the CBI data suggests a slight fall of wage settlements in manufacturing; the August trade deficit was a statistical aberration; the adjustment of house prices and consumer debt to a new equilibrium after the removal of rationing in 1981 is almost complete and the new non-inflationary equilibrium is just around the corner. There may be something in all of these ideas. But the financial markets have become doubtful about the fundamentals and I now share their doubts.

If my analysis is correct, the present tax treatment of owner-occupancy threatens not only future growth and employment, but through the Government's commitment to stock market values, its own election prospects. For once, political advantage and a statesperson-like concern for the unemployed and the future of the British economy coincide.

(*) Research for this article was undertaken with Olympia Bover.
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