Join our community of smart investors

Housing's productivity problem

Official figures last week showed that total hours worked rose by 1 per cent in the three months to January. With the NIESR estimating that real GDP grew by only 0.4 per cent in this time, this implies that productivity fell sharply, and has barely grown at all since the end of 2007.

Common sense says this should matter for house prices. This is because, in the long run, house prices should depend upon wages and in the long run these are set largely by productivity: it's no accident that real wages have stagnated as well as productivity since 2007.

History shows that common sense is right. Since 1975 (when data from the Nationwide Building Society began) house prices, adjusted for inflation, have risen at almost exactly the same rate as productivity - by 2 per cent per year compared with 1.9 per cent.

What's more, when house prices have deviated from the level of productivity, they have subsequently returned to it. In the late 1970s, late 1980s and mid-2000s real house prices were above the level warranted by productivity - and they subsequently fell sharply. And in the mid-1990s house prices were low relative to productivity - and they subsequently rose. There's a strong correlation (of minus 0.54) between the deviation of real house prices from productivity and the subsequent three-year change in house prices.

In this sense, productivity is an attractor for house prices. In the short term, they can deviate from the level predicted by productivity for all sorts of reasons: credit availability, speculative sentiment or a generous bank of mum and dad. Ultimately, however, house prices depend upon how rich we are. And this depends upon how productive we are.

Right now, this is not a huge problem for house prices. They are slightly above the level justified by productivity - based on the post-1975 relationship - but only by 5 per cent. House prices, remember, are still 15 per cent below their 2007 peak in real terms.

But productivity might become an increasing worry for those who are long of housing. If productivity stays stagnant and prices continue to rise at the rate they have in the last three years (by 4.6 per cent per year after inflation) then houses will be 20 per cent overvalued relative to productivity by 2019. This is the sort of misalignment that has led to crashes in the past.

This means we face two possibilities. One is that productivity stays weak and house prices don't rise much over the long term - the only question being whether they merely stagnate or we get a boom and bust. The other possibility is that productivity growth recovers to justify rising house prices.

Right now, however, there's little sign of the latter.