Emma Lyonette and Gabor Pinter.
What explains the strong comovement between the housing market and the labour market in the UK? This blog summarises the findings of recent research by Pinter (2015) that emphasises the role of real estate as an important determinant of firms’ borrowing capacity. This is because real estate is widely used by corporates as collateral when trying to obtain external financing. Fluctuations in real estate prices may therefore cause fluctuations in firms’ borrowing capacity, which then affects firms’ decisions to undertake new investment, to create new jobs and to destroy existing jobs. The paper shows that this so-called collateral channel is important in understanding not only the recent Great Recession but historical UK business cycles in general.
Stylised Facts
A popular narrative about the causes of the Great Recession is that the crisis was triggered by the collapse of the property market, which then spilled over into the rest of the economy including labour markets. Figure 1 is consistent with this narrative, showing that residential and to a larger extent commercial real estate prices started falling in the second half of 2007, followed by a sharp increase in the unemployment rate from 5.2% in 2008Q1 to 7.8% by 2009Q2. In the subsequent four years, real estate prices remained subdued and the unemployment rate remained high relative to pre-crisis levels, causing concerns for policy makers.
Figure 1: Residential and Commercial Real Estate Prices and Unemployment in the Great Recession
Note: The series for commercial and residential house prices are in nominal terms. Data on unemployment are from ONS, residential real estate price data are from Nationwide and commercial real estate price data are from IPD.
The collateral channel would suggest adverse movements in real estate prices reduce the borrowing capacity of firms, resulting in an increase (decrease) in job destruction (job creation), and leading to higher levels of unemployment rates. This is consistent with the fact that 40% of all borrowing from banks in the UK corporate sector is directly secured against commercial real estate. This ratio is even higher for small and medium size enterprises (SMEs) that generate about 50% of total UK employment and Gross Value Added (Benford and Burrows, 2013). Figure 2 shows that increases in the unemployment rate indeed coincided with a sharp and persistent fall in corporate credit growth during the Great Recession.
Figure 2: Corporate Credit and Unemployment in the Great Recession
Note: Corporate credit is in real terms.
In addition, house prices co-move at least as strongly with job separation rates (the rate at which employed workers lose their jobs) as with job finding rates (the rate at which unemployed people find new jobs). Moreover, the strong negative relationship between house prices and labour markets is a feature not only of the recent crisis, but characterises the last 30 years of UK business cycles as well, as shown by Figure 3.
Figure 3: House Prices and Job Separation Rates in the UK business cycle, 1985-2014
Note: House price data are from Nationwide and deflated by CPI; Job separation rate is calculated as in Petrongolo and Pissarides (2008). The logarithm of both series are HP-filtered with smoothing parameter, λ = 1600.
Results from an estimated DSGE model
To explain the stylised facts, a structural model is used whereby shocks that increase house prices raise the market value of collateralisable assets that firms own, thereby increasing their borrowing capacity and leading to an expansion in corporate credit supply, business investment and labour market activity. Intuitively, house price shocks can be thought of as unanticipated movements in house prices that are not caused by innovations in the real side of the economy such as technology or labour market conditions. These shocks may capture sentiments, animal spirits, or real shifts in household preferences for housing and all other disturbances that are not accounted for by the DSGE model. With regards to the UK business cycle, the research shows that these estimated shocks to house prices
- explain about 10-20% of output fluctuations and about 20-30% of fluctuations in corporate credit, unemployment and job separation rates via the collateral channel; and
- were a major cause in triggering the 1990 and 2008 recessions in the UK.
These results are similar to those found in the US. To highlight the importance of shocks originating in the housing market and the collateral channel which propagates these shocks into the wider economy, the DSGE model is used to compute the counterfactual paths of the UK economy that would have been realised if housing shocks had been absent.
Causes of UK recessions
The early 1990s were characterised by one of the largest collapses in real estate prices in UK post-war economic history. Real house prices started falling rapidly in 1989Q2 and by 1995Q4 the accumulated loss in real value amounted to almost 40%. Figure 4 shows the counterfactual paths (grey dashed lines) alongside the actual macroeconomic outcome (black solid lines). In the counterfactual economy, house price growth would have been stable, and the fall in output would have been muted. In large part this is because corporate credit growth would have remained positive all the way until 1991Q1, supporting business investment. The implications for labour markets are vast: the unemployment rate would have remained below 8% throughout the recession. Note that the decomposition also suggests that house price booms preceding the crisis contributed significantly to low unemployment rates and buoyant economic activity in the late 1980s. This result may potentially have implications for macroprudential policy as well.
Figure 4: The 1990-91 UK recession: What would have happened if house prices had not collapsed?
Note: To construct the counterfactual time paths of the variables, the contribution of the estimated housing demand shocks is subtracted from the observables, using the median values from the estimation.
The period surrounding the recent Great Recession saw a sharp decline in real house prices in the UK: they fell by about 20% over the period from 2007Q3 to 2009Q2. That was associated with a peak-to- trough contraction in real GDP of around 5%, while the unemployment rate rose from 5.2% at the start of 2008 to 7.9% in the three months to July 2009. To explore the contribution of negative house price shocks via the collateral channel to the UK macroeconomy, the counterfactual time-path of the business cycle is calculated under the assumption that house price shocks had been absent. Once again, Figure 5 shows the counterfactual paths (black dashed lines) alongside the actual macroeconomic outcome (grey solid lines). Adverse housing shocks started feeding into the macroeconomy at the beginning of 2008. The results suggest:
- Without these shocks, we would not have observed the series of consecutive negative house price growth rates starting from 2007Q3 and reaching a trough of -6.2% in 2008Q4.
- Quarterly output growth rate to be more than 1 percentage point lower on average throughout 2008; and
- contributed to the rapid increase in the unemployment rate. In fact, the estimation results suggest that the unemployment rate, which in reality had risen to almost 8%, would have remained below 5% till well into 2010, had house prices not collapsed.
- Indeed, as shown in Figure 5, quarterly corporate credit growth would have remained positive throughout 2008, had house prices not collapsed.
Though the estimation provides strong evidence on the causal link between housing shocks and the macroeconomy during the recent crisis, this channel does not explain the full story, and other mechanisms are also likely to have played an important role. For example, shocks to house prices explain a large part of corporate credit contraction in 2008, but they explain little of the ensuing tightening of corporate credit. The period 2009-2010 is interpreted by the estimation as being largely driven by adverse shocks to corporate financing constraints, suggesting that disruptions in financial intermediation (unrelated to the housing market) were responsible for the continuing corporate credit squeeze.
Figure 5: The 2008 UK recession: What would have happened if house prices had not collapsed?
Note: To construct the counterfactual time paths of the variables, the contribution of the estimated housing demand shocks is subtracted from the observables, using the median values from the estimation.
Conclusion
Given the increased importance of labour market variables in the recent policy debate in the UK (particularly the choice of the unemployment rate as a key component of the MPC’s forward guidance) as well as the increased financial stability concerns regarding house price dynamics, it is essential to better understand the drivers of the striking comovement between house prices and labour markets in the UK. The corporate collateral channel offers one possible narrative that can explain some fraction of this comovement. But this is not the only potential link between the housing and labour markets, and it would be interesting to explore alternative channels further. For example, with more detailed modelling of the household sector, and its balance sheet in particular, it would be possible to investigate the role played by channels operating through household debt and demand.
Gabor Pinter works in the Bank’s Centre for Central Banking Studies, Emma Lyonette is a former intern at the Centre for Central Banking Studies.
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Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.
