Undercover Economist

Why have house prices stayed so high?

The reluctance for prices to slump may have as much to do with psychology as with conventional economics

My forecasting record on housing prices leaves something to be desired. It’s not that I missed the slump in prices: on the contrary, when making a series about economics for BBC 2 in early 2006, I tried and failed to persuade my producer and director that a house price crash was pretty much inevitable. (They disagreed and we tore up the script for that episode.)

The problem is rather that the boom was so extreme that I was sure the bust would come far sooner and be much deeper. One way to see this is to look at “real” house prices, adjusted for inflation by Nationwide. They peaked at £128,000 in 1989 (measured in today’s money); the following slump ended only six years later, after prices had fallen by almost 40 per cent. The more recent boom makes that one look puny: as early as 2002, real house prices had topped £150,000 in today’s money and I was anticipating the mother of all crashes in 2003. And 2004. And 2005, 2006 and 2007.

Real house prices are still only 20 per cent down from their peak in late 2007 despite a ridiculous boom and an economic shock almost impossible to imagine when I first started my Cassandra act.

Why have house prices stayed so stubbornly high? Partly this reflects a genuine lack of supply in a country whose dense centre of economic gravity is made yet denser by the planning restrictions of the green belt. But the reluctance to slump may have as much to do with psychology as with conventional economics.

One of the key ideas in behavioural economics is “prospect theory”. Prospect theory assumes that individuals view risky choices relative to a baseline, framing them as losses and gains. Furthermore, they care more about avoiding losses than banking gains. This is odd, because the baseline is arbitrarily defined; yet it seems to be true.

What would this mean for house prices? It would mean that people are very reluctant to sell at a loss. This means more than just trying to get as much money as possible – most sellers want that. It means being unwilling to compromise, and being willing to lose the sale, if the proposed sale price is below the not-very-meaningful level of “what I paid for it”.

If sellers do behave like this, it would mean house prices would fall only with great reluctance. In particular it would mean that sales would dry up when prices fall below a previous peak. That’s certainly true: less than half as many mortgages are being approved now than before the crisis began. There is an economic reason why volumes should dry up as prices fall: a lack of access to finance could hit both price and volume simultaneously. But the psychological explanation may be even more important.

A study conducted by the economists David Genesove and Christopher Mayer provides clear evidence for this. Genesove and Mayer looked at a housing crash in Boston in the early 1990s, and they found that sellers facing the risk of a loss priced their condominiums more aggressively, winning somewhat higher sale prices but far higher risks of not selling at all. (Genesove and Mayer also present evidence that it is nominal losses rather than real losses that matter.) The researchers also argue that liquidity constraints – it’s harder to get a mortgage in tough times – do not fully explain the patterns they discovered. Prospect theory does.

What this means for the future of the housing market is, I’m sad to say, not clear to me. My reading of the economic fundamentals is still that housing is overpriced in the UK. With housing stagnating and inflation rates likely to fall to low levels again, it may be a long time before nominal house prices exceed the peaks of 2007. And it may be a long time before homeowners make peace with their losses.

Also published at ft.com.