Thursday, December 05, 2002
The housing bubble revisited
Posted by David Smith at 04:55 PM
Category: David Smith' s magazine articles

Once again the topic dominating the dinner tables of Middle England coincides with that of the top tables of economic policymakers. What is going to happen to house prices? Is there a bubble and, if so, is it going to burst? If not, how big a danger does the house price boom pose to economic stability?

House prices are certainly rising. At time of writing the latest Nationwide figures show prices up by 24% on a year ago. The housing market is the main motor behind strongly rising consumer borrowing, up by nearly 14% on the year.

It is also an important driver of consumer spending. This year, according to the Centre for Economics and Business Research (CEBR), mortgage equity withdrawal will total 39 billion, and finance nearly 6% of consumer spending. Equity withdrawal happens when people re-mortgage or move house, taking some of their accumulated equity out for non-housing purposes.

So the strength of the housing market, and the immediate effects of that strength, are not in doubt. Nor, while booming house prices are usually seen as an evil, should the benefits be understated. At a time of falling equity markets, housing has been a source of rising personal sector wealth, without which the economy would have been deprived of at least some of the benefits of consumer spending growth, the main bulwark against recession over the last couple of years. What is going to happen now?

Let me start by putting a few cards on the table. I am not one of those people who worry each time house price inflation gets into double figures. Housing is one of the those "swing" markets where a small change in the supply-demand balance can have a big impact on prices. It is perfectly possible, as we have seen, for high house price inflation to go hand in hand with very low general inflation.

The second card I would put down relates to affordability. Many people swear by the house price-earnings ratio. This does as it says on the box, measures the relationship between house prices and average earnings. Over the long-term, the ratio averages about 3.5. Currently it is well above that, at well over four times' earnings nationally, and decisively so in London, where the ratio is nearer six.

But the crude house price-earnings ratio does not take into account another important determinant of affordability, the level of mortgage rates. I have been a strong advocate of the "gearing" case for higher house prices. People have adjusted to the fact that, as I wrote here a couple of months ago, we have moved into an era of permanently lower interest rates.

Purists would say that what matters in this context is the level of real, that is after-inflation, interest rates. A mortgage rate of 6% at a time of 2% inflation, in other words, is no different to a mortgage rate of 15% when inflation is 11%.

I'm not at all sure about that. For one thing a cut in the nominal interest rate has the most decisive effect on the proportion of income that goes towards mortgage payments. For another, it is not clear what measure of inflation one should choose. If a borrower is taking out a loan for the purpose of house purchase there is a case for saying that the inflation rate on the asset concerned, in this case housing, is the appropriate measure. On this basis, in real terms mortgage rates are currently negative.

So is it all hunky dory? Should we celebrate rather than curse the housing boom? Not quite. I was very comfortable with my gearing and "swing market" arguments until a few months ago. What has made me uneasy has been the recent acceleration in house prices, at a time when there were good reasons to expect a slowdown. Over the summer the three-month annualised rise in prices hit 40%.

We known why this was. Ordinary home-buyers were responding to low interest rates while speculators saw housing as a better bet than, for example, the stock market.

What we began to see, in other words, was a market taking on classic "bubble" characteristics, with buyers apparently determined to get in before prices rose even further, whether or not they regarded a property as good value or comfortably affordable. That way lies extreme danger.

The position now is that the longer this period of rapidly rising prices goes on, the greater than danger of a painful correction, including falling prices. What could bring that about in the absence of a sharp rise in interest rates? The answer is that it could occur for macroeconomic reasons - slower growth in incomes and an upward drift in unemployment - both of which are quite likely. It could also occur because of the housing market's internal dynamics. Once buyers start to believe prices may fall, demand will drop right back. If, at the same time, there is forced selling by some overstretched borrowers, the impetus will be there for a sharp drop in house price inflation, if not outright price falls.

The CEBR, for example thinks that house price inflation will decelerate to under 3% by early 2004. That would mean, in some areas, falling prices.
We should not be too gloomy about this. A repeat of the early 1990s, with the horrors of widespread negative equity, is not in prospect. Sometimes, too, people need to be reminded that prices can go down as well as up.

From Professional Investor, December 2002-January 2003