House prices: The b-word

May 09, 2014
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UK house prices rose at 9.1 per cent in the last 12 months and are creeping ever closer to the levels achieved before the 2008 crash. So is there, or is there not a property bubble in Britain? That question sends anyone who pursues it tumbling down a rabbit warren of claim and counter claim. This is in large part down to that poisonous little word “bubble”, which has in the past proved such a slayer of economic reputations. In the run up to the calamity of 2008, when US house prices and financial assets were well into bubble territory, almost no economic experts or forecasters spotted it—certainly no central bankers.

The b-word has ever since assumed a great and heavy significance. Spokesmen from Number 10 blench at its use. Senior analysts at the Royal Institute of Chartered Surveyors are clear that there is no bubble.

But as Jonathan Portes, Director of the National Institute for Economic and Social Research points out, “It is very difficult to spot bubbles until they burst—and this can take considerably longer than one might think possible.”

So the housing market may or may not be sitting on the surface of an ever-expanding bubble, but that word is freighted with such great historical significance that it is best in this case to step past it, and to ask instead whether the UK housing market is a problem.

“UK house prices are at historically high levels in relation to incomes,” says David Kern, the Chief Economist at the British Chambers of Commerce. “But when interest rates start rising from around mid-2015,” he adds, “the finances of many households with big mortgages will come under increased pressure.”

This is the nub of it—the debt pile. Three quarters of all UK bank and estate agency UK debt is given over to mortgage lending, a point made in a speech given at the beginning of May by Jon Cunliffe, a Deputy Governor of the Bank of England. He went on to note that, of all the warning lights he sees, “Growing momentum in the [property] market is now in my view the brightest light on that dashboard.” The Bank of England has already introduced more stringent criteria for mortgage lending and the consensus among City economists is that interest rates will rise in the first half of 2015, a view that is already reflected in interest rate futures markets. The housing market could be brought under control in a way that avoids trouble, Cunliffe said. However, he also noted darkly that, “other outcomes are very possible.”

When house prices can rise no further and instead start to slip backwards, the effect can be very nasty. Cunliffe noted in his speech that recessions associated with housing busts have tended to be over twice as severe as those without. Property price falls tend to be self-reinforcing. If property values decline, then homeowners have less borrowing power, which means in turn that they consume less. A combination of tighter credit conditions and falling property prices can unite to cause prices to fall even further, at which point the downward spiral takes hold.

Could such a spiral occur in the UK? The OECD, the international economic think tank, recently signaled its alarm at the state of the UK housing market, noting in a report earlier this month that current house prices “significantly exceed long-term averages relative to rents and household incomes.”

Alarm was stoked further by comments reported in Thursday’s Financial Times by three former Chancellors of the Exchequer—Lawson, Lamont and Darling—a triumvirate with substantial experience of economic distress. All three are alarmed at the state of Britain’s house prices.

The argument over whether there is or is not a bubble will only be settled in retrospect. Even so, there is a widespread view that Britain’s housing market is a big problem—there is also a notable consensus on the long-term solution. Philip Booth, a Director at the Institute of Economic Affairs says: “the incredibly high house prices in the UK are… a sign of our very restrictive planning regime. If that were liberalised properly, we could see a fall in house prices that lasts a generation and that would be a thoroughly good thing.” According to Jonathan Portes, the “fundamental problem with the UK housing market is lack of supply.” Alistair Darling told the Financial Times: “Supply of housing is the biggest single thing. Unless supply can be increased substantially, we will exacerbate that situation.” Lucy Thornycroft, CBI Head of Construction, says that “we need to see urgent action taken to boost housing supply, roughly doubling the number of houses we build a year.”

There may be disagreement on the precise nature of the housing problem—the long-term solution, however, is clear. Interest rates may rise, lending standards may be adjusted, but really the only answer it to build.