International evidence indicates that there is an association between the growth in mortgage advances, house prices and default risk in that house prices have been more volatile in those countries where financial market liberalization is more advanced. However, some care is required in clarifying the transmission mechanism since there are important implications for policy, particularly concerning the efficacy of lending controls.
Figure 7.2 showed the UK mortgage debt to income ratio. As discussed, the strong growth in the ratio took place from the early 1980s, when liberalization began. Before that date the ratio had been broadly constant. During the growth period, conventional borrowers had greater scope for choosing the amount of finance they required. Therefore, over that period, the observed volume of mortgages represented demand rather than supply. But prior to the 1980s, when mortgage advances were much weaker, demand was limited by shortages. Furthermore, after the GFC, borrowers faced lender-imposed constraints.
As a simplification, the excess demand for mortgages (written as ƛ ) can be expressed as (8.1a).
Prior to the early 1980s: Md -Ms >0
1980s – 2007: Md -Ms =0
Post 2007: Md -Mss >0 (8.1a)
M = Outstanding stock of mortgages; Md and Mss are mortgage demand and supply respectively
Now consider the house price equation (8.2a), taken from Table 3.1 (the fourth equation) and the definition of the cost of capital (8.3a), which includes possible credit restrictions. Additionally, the cost of capital includes a risk premium discussed in the main text.
ln (g) =2.46 ln (Y) + 0.118 ln (RW) -0.045 CC -1.776 ln(HS)(8.2a)
g = Real house price (expressed relative to general consumer prices)
Y = Real household income
RW = Real household financial wealth
HS = Housing stock
CC = Cost of capital
r = Market interest rate
δ = Depreciation rate
mt = Maintenance expenditure (as a percentage of the property value)
pt = Property taxes (as a percentage of the property value)
PH = Expected nominal capital gain on the property