Sunday, February 06, 2005

Economic Outlook: David Smith: House prices may wobble but won’t crash to earth


ON this Sunday morning, with the spring daffodils pushing through the cold February soil, talk of a housing crash may seem gloomy. But that is what I want to talk about.

Not that such talk is new. The first housing-crash story I could find in the present cycle came in 1996, when one Bob Beckman predicted a 20-year fall in prices. There was another batch in 1997, when the fear was that Labour’s election would hit house prices hard.

In 1998 and 1999, when the stock market was booming, there was a steady trickle of housing-crash predictions, building further when the stock-market boom turned to bust in 2000. The September 11 attacks on America persuaded many that housing was about to take a dive and, in the three years since, talk of a housing crash has built up to a crescendo.

So why revisit it? On Thursday, at the RAC Club, I debated the issue with Roger Bootle, head of Capital Economics. The event, kindly sponsored by Sector Treasury Services, was the unexpurgated version of a briefer run-in we had before Christmas. So how did it go? As I put it, from the “soft landing” perspective, there are three key questions. The first is whether a house-price crash can happen without an overall recession in the economy. Every previous “crash” in house prices, in the depression of the early 1930s, in the turbulent 1970s (1973-76), in the late 1970s and early 1980s, and most recently in the early 1990s, was accompanied by a severe recession. The crash of the early 1990s followed a doubling of interest rates, from 7.5% to 15%, and a near-doubling of unemployment, from 1.6m to 3m.

Bootle’s argument was that house prices then started to fall ahead of the rise in unemployment. Both housing and the job market were subject to the same negative influence, a sharp interest-rate rise.

Except that the housing crash of the early 1990s did not really get going until unemployment was rising sharply and small firms were failing in their tens of thousands. By mid-1990, prices were just 1.6% lower than a year earlier. Over the following 12 months, prices slipped by a mere 0.2%. The worst year for the market was 1992, in the autumn of which prices were recording a 12-month fall of 8.7%.

This came after the big rise in unemployment and when the government lost control of economic policy (subsequently grabbing it back) with sterling’s expulsion from the ERM. So the claim stands. Can house prices crash without a general recession? I think not. Is there going to be such a recession? After 50 successive quarters of growth there is no sign of it.

The second argument related to actual, rather than “real” or inflation-adjusted, house prices. There were only two occasions in the 20th century when actual prices fell substantially — during the depression of the early 1930s and in the early 1990s. On both occasions, curiously, the peak-to-trough fall in prices was 13%.

Mostly, as in 1973-76, 1979-82 and partly in the early 1990s, a much bigger real fall occurred because prices stagnated while more general inflation — 27% in 1975, 22% in 1980, 11% in 1990 — ran its course.

Bootle’s argument is that, with inflation low, actual and real will become more or less the same thing. Without inflation to disguise things, actual prices will have to fall, by 20% in his view, to correct the market’s overvaluation.

Except, to me, that is not how the housing market works. Sellers will not cut prices unless forced to do so by economic circumstances. Most house moves are voluntary; people have a choice whether to go ahead or not. If the choice is between selling at a price they consider too low, most will withdraw the property from the market. House prices, in a phrase invented by Lord Keynes, are “sticky downwards”. This is a recipe for stagnation, not a crash.

My third argument was about the house price/earnings ratio, the traditional measure used to assess whether the market is overvalued. Depending on which version you use, the ratio is currently about 5.5, or even higher, against a long-run average of under 4. Bootle said this showed the need for a drop in prices.

My take was rather different. Leaving aside the question of whether the notion of average earnings belongs to the age of mainly industrial employment and has much meaning these days, two things have happened to the housing market in recent years which justify a permanent revaluation. The first was the liberalisation of the mortgage market to new entrants in 1982, and which may only have come fully on stream with the intense competition of the 1990s and beyond. Before 1982 mortgages were rationed, building societies and local authorities the only providers.

The other effect has been the permanent change in interest rates. In 1979-97 the base rate averaged 10.4%; in the period since, it has averaged 5.3%. This change justifies a big shift in the house price/earnings ratio. Bootle argued correctly that real (after-inflation) interest rates have not come down as much as actual rates, and that homebuyers no longer get mortgage relief. But actual interest rates — and actual monthly mortgage payments — are the main determinant of what people will pay for houses and how much they will borrow. The change here has been huge and, as I say, looks permanent.

To be fair to Bootle, there were other arguments. In real terms, he argued, the recent house-price boom has been more powerful than its predecessors — prices rising strongly at a time of low inflation. House prices, he noted, have risen more sharply than other assets, most notably equities and commercial property.

The interest-rate burden on homebuyers may be low, he said, but when debt repayment is taken into account, it is set to increase strongly. First-time buyers are being kept out of the market across the country by high prices, and the difficulty of scraping together a deposit.

All good points. But none seemed to me, or to an audience that voted 2:1 for a soft landing, to be clinchers. The latest evidence from Nationwide and Halifax suggests prices rose last month. Mortgage approvals appear to have stabilised. If it looks like a soft landing, which it does, it probably is.