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Building safeguards
For the Bank of England, the price of stability is eternal vigilance if yet another disaster in the housing market is to be prevented. House prices are surging. Can disaster be far behind? Such anxiety is only too understandable. The price of housing, relative to average earnings, has surged twice in three decades. In each case, the rise was followed not just by a housing market collapse, but by a painfully deep recession. According to the late Christopher Dow, output fell 8 per cent below trend in the recession of 1973 to 1975 and nearly 12 per cent below trend between 1989 and 1993.(Christopher Dow, Major Recessions: Britain and the World, 1920-1995 (Oxford University Press, 1998). Such instability is precisely what the monetary policy committee of the Bank of England was established to prevent. Unfortunately, comments made by its newest member, Sushil Wadhwani, last week (FT, September 2), suggest that not all members of the MPC fully understand this. Happily, the surge in house prices has not yet gone very far (see chart). After the last and biggest of all the market booms, in the late 1980s, the ratio of prices to average earnings fell for seven years, to a trough of less than 3.4 in 1996. Since then it has risen only to 3.7, slightly above the average of about 3.6. So housing, if not cheap, is certainly not expensive by historical standards. For this reason, the recent rise can be viewed as no more than an unavoidable and desirable correction. Nevertheless, there are two reasons for not letting the matter rest at that. First, any sustained rise in house prices tends to have an exceptionally strong impact on household spending, largely because it is extremely simple to borrow against a rise in housing wealth. Second, all asset prices tend to overshoot equilibrium levels. Housing is certainly no exception to this general rule. Already in the first quarter of 1999, so-called equity withdrawal - the use of mortgage lending to finance general spending - was £2.8bn, up from a mere £600m a year before. There is every reason to expect this figure to grow further. As Deutsche Bank notes in a recent analysis of the domestic housing market, prices have been rising at an annualised rate of 18 per cent in recent months. Meanwhile, the base rate of interest stands at 5 per cent, the lowest since 1977. The combination of soaring prices with cheap finance and an increasingly robust economy must make equity withdrawal highly attractive. This same combination also makes further rapid rises in house prices very probable. The initial cost of housing finance is now as low as at any point in the last three decades (see chart). With the cash-flow cost of house purchase so modest and interest rates below the likely appreciation in house prices in the short term, the incentive to buy now rather than later is close to overwhelming. Then, as house prices soar, other potential buyers will feel tempted to jump, before costs go out of reach. This is how huge price overshoots have occurred in the past. There are two distinct ways of discounting these dangers. The first is to point to the regional nature of the surge in house prices. House prices have been rising strongly only in London and, to a lesser extent, the rest of the south of England. Yet, while true, this pattern is not as encouraging as many idly suppose. Prices never rise evenly across the country. Ultimately, however, high prices in the south do tend to reverberate across the rest of the country. So this cannot be dismissed as a purely local problem. The second way of calming the worriers is to argue that the economy can absorb additional demand generated by a housing boom, without any significant rise in inflation. If so, there must be substantial slack in the economy. That is certainly not what the Organisation for Economic Co-operation and Development believes: it estimates that the economy is running fairly close to its long-term trend level of output. The proposition that this view is too gloomy implies that there has been a sizeable, but as yet unproven, improvement in potential output. The more optimistic position on supply is, in essence, the one advanced by Mr Wadhwani. Such optimism has, alas, all too many precedents at this stage of the cycle. The view that the growth potential of the economy has been transformed - or, worse, that allowing faster growth in demand would itself help generate the needed additional supply - was used to justify demand spurts in the early 1960s, early 1970s and late-1980s. In each case, the attempt ended in tears. It is also naive to suppose that housing market disequilibria of the scale of the 1970s and 1980s can be brought under control either quickly or smoothly. If the Bank stood aside while the economy suffered another house price overshoot, it could take years to bring the instability back under control. For this reason, it would be a mistake to act on the assumption that the economy has already been transformed. It would be far wiser to respond only to evidence that this is, in fact, the case. Similarly, it would be a gross error to ignore house prices merely because their impact on the economy is unpredictable. The price of stability is eternal vigilance. At the moment, both the relative price of housing and its recent rate of change are at roughly the same point as they were in early 1987. Everybody now knows what happened then, in two brief, but ruinous years. That must not happen again. If the MPC allowed it to do so, it would have failed - and those who refused to support a robust response would deserve to be sacked. |