Economic View: A downturn is inevitable. Next year would be tough, but postponing it until 2010 would be even tougher
Oil prices, the credit crunch and the housing market all point one way, but any attempt to prolong the boom will make the crash far worse
Sunday 04 November 2007
It is seven years since the peak of the 2000 boom. No economic upswing goes on for ever and this one is now mature. There are three good reasons to worry about a coming downswing.
The first is the behaviour of oil prices. The oil price rise since 2004 now matches (in real terms) those that followed the Yom Kippur war and the fall of the Shah (see chart). Those events ushered in savage world recessions in 1975 and 1980. We can hope that it will be different this time around (a) because inflation is under much better control and (b) because the beneficiaries of oil price increases will spend more of the money. But it remains true that higher oil prices push up costs for producers and reduce the spending power of consumers. They are bad news for business in Europe, America and Japan.
The second cause for concern is the troubles that have recently afflicted financial markets. A rise in interest rates is always upsetting for business, which over the summer months suddenly found that credit had, at best, become a lot more expensive and, at worst, dried up all together. Many M&A deals, previously buoyed by cheap and freely available credit, are now being questioned. City firms, which have thrived on the strong M&A activity normal at this stage in the cycle, will be among the first to be hit by the downturn.
The third cause for concern is the housing market. It is not just that London house prices will be quickly affected by any cutback in City bonuses. There is a more fundamental problem that house prices have been driven to unsustainable levels by a long lending boom that may now be coming to an end. The more serious problem is in the US (more on that below). But the UK problem is closer to home.
In the UK the average house is worth nearly five times average earnings. This is an astonishing multiple. It means that if prices rise by 10 per cent, fairly common in recent years, the average house of the average Brit earns half as much as he does. The downside is that when the value of our houses stop rising, we feel a lot less well off. Housing data since June suggest prices may have reached a plateau. A raft of non-price statistics (proportion of asking price achieved, months taken to sell) confirms that picture.
This matters, because when house prices fall relative to incomes, we consume a smaller proportion of our incomes (see chart). The UK consumption ratio is now higher than in the 1999-2000 boom, and higher even than in the infamous Lawson boom of 1988-89. It has been carried to that level mainly because banks and building societies have been prepared to lend an ever greater multiple of incomes to house buyers. They believe the lending is prudent because it is underpinned by the value of the house. But in aggregate it is the other way around: the high prices would not be achieved but for the loans. The loans may look safe relative to value but in reality they are risky.
It is not just that house prices are high in relation to income. They are also now priced at a very high multiple to rents. House price optimists point to the housing demand that is being created by the massive influx of immigrants. That has indeed been an important ingredient in the present housing boom. But despite this influx, housing rents have remained remarkably flat. Supply has responded to demand. Buy-to-let landlords have provided the kind of accommodation that people need. But as house prices have continued to rise, landlords entering the market are finding that rents are not covering their interest charges.
It is thus quite easy to imagine a scenario in which a rise in interest rates turns a significant proportion of buy-to-let landlords into forced sellers, triggering a downturn in the UK housing market. The effect on consumer confidence leads to a fall in the consumption ratio and a more generalised economic downturn.
Will the Bank of England allow that to happen? It may not be able to prevent it. The US housing market is already in trouble, with house prices clearly in decline in a number of American cities. That decline has hugely increased the risk attached to so-called sub-prime mortgages (housing loans to poor people). There was always significant risk of default on these loans. But nobody worried much about that because they were backed by houses which could always be sold to pay off the mortgage arrears.
But when US house prices started to fall, the risk premium attached to sub-primes rose sharply. Worse still, nobody knew where these risks lay, because the mortgages had been packaged up and sold. So a risk premium was attached to all lending. The news headlines over the summer were dominated by the credit crunch discussed above. Short term interest rates rose across the board by 1 per cent. That event has already led to the first UK bank run in more than a century. It also prompted a sharp about turn from the Fed, continued this week.
If the Bank of England follows suit, the disasters described above may be averted. But those of us with long memories remember two other occasions in which official interest rates were cut in response to a crisis with its origins in financial markets. Almost exactly 20 years ago monetary policy was eased in response to the huge stock market crash on Black Monday. And nearly 10 years ago there was a similar easing following the Asian crisis. In both cases the immediate objective was achieved. A crisis with its origins in financial markets was prevented from spreading into the wider economy. But in both cases the effect was to prolong a boom and make the crash, when it came, even worse. If the authorities prevent a significant downturn next year, expect a worse one in 2009 or 2010.
Bill Robinson is head of economics, KPMG Forensic
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