"Let Britain’s housing bubble burst"

I wish we had someone as well regarded as the Financial Times’ Martin Wolf giving the same message in the US. Wolf stresses that prosperity built on overpriced homes is illusory. He pans some ideas that are already being road tested in the US, and says attenuating an inevitable fall in prices is unsound. And he gives himself license to get worked up, which he does quite colorfully.

From the Financial Times:

What has happened to British phlegm? Instead of greeting news of falling house prices and tightening lending with aplomb, people shriek that the sky is falling. Steven Crawshaw, chairman of the Council of Mortgage Lenders, warns that it is “a real possibility . . . that net lending in 2008 could reach only half last year’s level unless additional funds become available”. Smaller mortgage lenders, dependent on their ability to sell mortage-backed securities, could even be forced out of the market. In sum, the time has come for a bail-out.

I have three answers to this cacophony of special pleading: first, anybody who thinks it is a duty of the state to help keep housing expensive is crazy; second, policymakers should respond only to clear market failures; and, third, with a floating exchange rate and an independent central bank, the UK can weather the storm if it keeps its head.

It is high time the British realised a people cannot become rich by selling ever more expensive houses to one another. According to the International Monetary Fund’s latest World Economic Outlook UK house prices are more overvalued, relative to economic fundamentals, than those of almost any other high-income country. At long last, investors in mortgage-backed securities, all too aware of what has happened in the US, have realised the dangers in the UK.

They must understand that it becomes extraordinarily difficult to know what such securities are worth as soon as house prices start to fall. They must also be aware that UK house prices have risen by a good 150 per cent since 1996, in real terms. Indeed, It would take a 25 per cent fall in real prices to put them on to the 1971-2007 trend line, last hit in January 2002. Such a decline is conceivable. Prices might overshoot downwards, but they are nowhere near that position now.

Peter Spencer, chief economist of the Ernst & Young Item club, argues that the government should step in, by borrowing to fund the mortgage market. With great respect, I think this notion is mad. It is wrong for the government to fund people to purchase houses at what may well prove the beginning of a long slide in prices. It is tantamount to the financial debauching of minors. As important, if you believe, as I do, that house prices probably must fall, it is better for this adjustment to be swift than be dragged out over many years.

So should the government do nothing at all? No. Since mid-March, spreads between rates on interbank and official three-month and six-month lending have been some 20 to 25 basis points higher in the UK than in the US or eurozone. This, it is argued, reflects the illiquidity of mortgage-backed securities. Lenders, argues Mr Crawshaw, hoard cash because they are not sure whether they will be able to borrow in future.

Whatever the source of the problem, a case exists for further action by the Bank of England in its role as lender of last resort. At present, it is working, in conjunction with the Treasury, on a scheme to swap high-grade mortgage-backed securities for government debt for terms of one to three years, after a sensible “haircut”. But credit risk would still remain with the banks.

This facility would be available at all times, but would be limited to securities created up to the end of last year. All that is now needed is for the Treasury to agree to create the needed gilts. The aim of this would be to remove liquidity constraints, not provide a bail-out or reopen the market in mortage-backed securities. The latter may well be gone forever, as can happen to markets in lemons.

In all, this looks sensible. If it succeeds, net mortgage lending may remain lower than before. Yet even if it were to halve, as some fear, the nominal stock of outstanding mortgage debt would grow by a bit over 4 per cent this year, or much the same rate as nominal gross domestic product. The idea that the stock should grow faster than GDP forever is nonsense.

After house prices peak, I would expect the ratio to fall, not just cease rising. Those arguing for still higher growth in net mortgage lending are arguing that the government must subsidise even more house-price inflation and the lenders who have fuelled it. This is demented.

Yet, some will protest, this is a recipe for a recession. This is false. Even the IMF argues that the economy will continue to grow this year and next, at about 1.6 per cent. After 62 quarters of sustained growth, would that be a tragedy? Moreover, the real reason for slower growth is the need to hit the inflation target. The country needs lower inflation, whereupon the Bank will have room to cut interest rates.

The adjustment of the economy towards exports and away from domestic spending is now, at last, under way. Fortunately, the exchange rate is taking much of the strain. In eight months, competitiveness has improved by 16 per cent against the UK’s eurozone partners, something Spain or Italy will only achieve painfully, after years of disinflation.

A combination of close attention to the liquidity logjam and flexible monetary policy is all that is needed. It is not the government’s job to reflate house-price bubbles. It would have been a good idea if it had done more to prevent them, instead. Now it must let events undo that mistake, rather than try to compound it.

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4 comments

  1. doc holiday

    I was curious as to what was meant by overvalued economic fundamentals>>>

    WORLD ECONOMIC OUTLOOK
    Managing Housing Sector Boom-Bust Cycles
    By Roberto Cardarelli, Deniz Igan, and Alessandro Rebucci
IMF Research Department
    April 3, 2008

    http://www.imf.org/external/pubs/ft/survey/so/2008/RES040308A.htm

    An aggressive easing would be justified in response to concerns from a rapid slowdown of the housing sector, but some “leaning against the wind” may also prove useful to limit the risk of a buildup of housing market and financial imbalances.
    Finally, it is important to recognize that monetary policy must be complemented by regulatory policies to limit risks of unsustainable house price bubbles because of imprudent lending practices.

    In the latest World Economic Outlook, Roberto Cardarelli of the IMF calculates the share of the increase in real house prices between 1997 and 2007 that cannot be accounted for by fundamental factors such as lower interest rates and rising incomes. This “house-price gap” is greatest for Ireland, the Netherlands and Britain, where prices are about 30% higher than can be justified by fundamentals.

    The IMF’s so-called ‘house price gap’ is based on the extent to which house prices can’t be explained by economic fundamentals. The fund’s latest World Economic outlook suggests house prices in Australia have been overvalued by 25 per cent over the past decade.

  2. doc holiday

    Yves,

    Sorry but I have to chase this down here (from my previous IMF post). There is an interesting switch from GDP to PCE which IMF screwed up on last year, along with The Fed, et al … NAR comes to mind, SIFMA…

    Re: …past relationships with fundamentals, in addition to consumer price inflation and the output gap (that is, the difference between potential GDP and actual GDP, or output).

    >> Dont’t killl me, I mean no harm here< < Transcript of a Press Briefing on the Preliminary Findings of the 2007 U.S. Article IV Consultations
    By John Lipsky, First Deputy Managing Director

    North American Division Chief Tamim Bayoumi
    Washington, D.C.
    Friday, June 22, 2007

    A follow-up here.
    QUESTIONER: A follow-up on growth estimates, in the report, you mention here that it’s dangerously close to the 2 percent stall speed which puts in a recession, puts the U.S. in a recession, but you’re saying on the other hand that you’re very optimistic that it’s going to be 3 percent next year, that growth is looking pretty good now. It seems there’s something of a disconnect. What’s happening between now and next year when we hit 3 percent?
    How is the economy going to accelerate in that time?
    MR. SINGH: On this thing of the stall speed, historically, whenever the U.S. has entered around 2 percent growth rate, you’ve tended to see recessions, but this time that is not our forecast. In fact, we expect something of a soft landing, and the reason is because some of the other factors that you associated with recessions are not in place. Real interest rates, in particular, are actually quite low and unemployment, most importantly, is also very low. So we have, I think, the fundamentals that are needed, that we see as supporting the economy.
    In addition, there are a few other factors that are very strong. Reflecting the low unemployment, consumption growth is strong. As Tam mentioned, the position of the corporate sector is also unusually strong. Profit growth is still high. Margins are high. So that should permit a recovery in business investment. Finally, the global situation is rather good in terms of the U.S.’s trading partners, so there should be more opportunity for exports to also support U.S. growth.
    Altogether, the stars are well aligned for a soft landing for the U.S. and to pick up now, to recover from the soft patch that it’s been in.

    QUESTIONER: You say core inflation will be below 2 percent. Is that in both 2007 and 2008?
    MR. BAYOUMI: Yes is the short answer. Core inflation, there are various subtleties here, one of which is which measure of core inflation you’re talking about, whether you’re talking about the PCE deflator, which is the Fed’s preferred measure, or the CPI, which is another measure of core.
    We tend to focus, as the Fed does, on the PCE deflator as a better measure. That’s already at 2 percent. We foresee a gradual fall, and I think that we would certainly see that coming down in 2007 and 2008.
    I think the core CPI deflator, which tends to be slightly higher and is at present at 2.3 percent, will also come down gradually. Certainly over the course of 2007, we would predict that it would come down to 2 or below.
    MR. LIPSKY: Let me speak clearLY. That’s with an assumption of energy prices that are broadly constant from current levels.

  3. Anonymous

    Last post on IMF:

    Regional Economic Outlook Western Hemisphere APR 08

    http://imf.org/external/pubs/ft/reo/2008/WHD/ENG/wreo0408.pdf

    The U.S. economy is expected to slow substantially this year, with Q4/Q4 growth of –0.7 percent in 2008 bringing annual average growth down to just 0.5 percent, from 2.2 percent the year before.

    Housing starts have more than halved from an annualized 2.3 million in January 2006—the highest rate in33 years—to about 1 million two years later. However, inventories of new homes for sale have risen to close to 10 months’ supply, a level not seen since 1981. With this substantial overhang, prices are now falling in nominal terms on a national basis, and further declines of 10–20 percent (depending on the index being used) are widely expected over the next two years.

    The latest senior loan officers’ survey suggests that lending standards are being tightened across all types of loans, from residential mortgagesto commercial and industrial clients.

    The most likely outcome is that the United States will experience a downturn during much of 2008. In the baseline scenario, consumption, until now the main engine of the economy, slows sharply,reflecting the various strains on consumers.

    See Also:

    http://www.imf.org/external/pubs/ft/weo/2008/01/pdf/c2.pdf

    In 2009, consumption will remain slug-
    gish, as households continue to raise their saving rate after a long period during which personal wealth was boosted by buoyant capital gains on assets rather than by savings from income. Net exports will continue to be a bright spot, bringing the current account deficit down further to about 4.2 percent of GDP, notwithstanding sustained high oil prices.

    Risks around this lower baseline are still
    somewhat weighted to the downside, particu-
    larly for 2009.

    Models with credit constrained consumers or finite planning horizons generated positive output effects and were also supported by microstudies. Other modeling approaches relied on nominal wage and price stickiness and imperfect competition among producers, both of which can raise real wages and output in response to a fiscal demand shock.

    * For other factors, see Blinder (2004).

  4. a

    “Yet, some will protest, this is a recipe for a recession. This is false.”

    I’m with Wolf up to here but lose him with this comment. IMHO here Wolf is showing the same mindset as those he criticizes. That is, those who want to prop up housing prices are basically arguing that you need to do that to avoid recession. While Wolf has lots of good reasons why one shouldn’t prop up prices, it looks like he is avoiding the hard choice (do something vs do nothing and recession) by saying that there’s not going to be a recession anyway. So I’m left in doubt whether Wolf would change tack if he thought that doing nothing *would* cause a recession.

    Myself, I think the choice is false. But the real choice is not “do something vs do nothing and no recession” (as Wolf seems to think), but “do something and recession vs do nothing and recession.”

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