Endogenous UK Housing Cycles and the Risk Premium: Understanding the Next Housing Crisis

Despite the lessons of the post-2007 housing crisis, it would be dangerous to suggest that there will be no similar future events. Here we define a 'crisis' as a period of sustained worsening in affordability followed by a collapse in house prices, both of which were features of the 1996-2009 period. Extending the standard life-cycle housing approach to a three-asset model which incorporates interactions with financial markets and uncertainty, it can be shown that endogenous housing cycles can explain volatility. Three parameters drive the system - the income and price elasticities of housing demand and the degree of risk aversion. Furthermore, a key feature of UK housing policy over the last ten years or more has been an attempt to increase housing supply in order to stabilise affordability. The model demonstrates that stabilisation is impossible for any plausible level of construction, if affordability is measured by the ratio of house prices to incomes. Nevertheless, the market has built-in stabilisers; this is demonstrated through the use of stochastic simulations, which illustrate the dynamics of house prices implied by our expected utility model. The model derives explicitly a housing risk premium as a key determinant of the user cost and, hence, house prices and affordability, a factor commonly ignored in many housing models. Moreover, we find that exogenous, persistent 'ups and downs' similar to the Great Moderation - Global Financial Crisis period complement the endogenous propagation mechanism of our model.