Economic View: Investment's coming home

The problem is that when short-term rates go up it's not the housing market that suffers. It's the rest of the economy

The row brewing between Gordon Brown, the Chancellor of the Exchequer, and Mervyn King, Governor of the Bank of England, over the correct measure of inflation to use reveals the flaw in the Bank's so-called independence. It may be independent, but the Chancellor sets the inflation target that determines its independent behaviour. Some see the proposal for the adoption of the European system of Harmonised Index of Consumer Prices (or hiccup as it is inevitably known) as being a sop to the pro-Europeans. Others see it as a way of obscuring the impact of council tax rises. That's as may be, but the real reason for changing the inflation measure is that Brown simply cannot afford to let interest rates go up.

This is all down to our curious mortgage system, whereby UK householders have a 30-year liability, a mortgage, funded at three-month money rates. Unlike continental Europe, where mortgages are at a fixed rate, or the US where they are fixed rate but re-financeable if long rates fall, a rise in UK short rates hits the whole of the mortgage sector rather than just the marginal borrower. Thus, every move in short-term interest rates translates into either more or less money for householders to spend at the end of the month. In effect, interest rates act like tax increases, or tax cuts. This is fine when rates are coming down, but alarming when they have to go up. I would go so far as to say that the boom and bust to which the UK economy is prone, and which Brown has promised to eliminate, is almost entirely a function of our mortgage system. It is also why UK politicians were historically so keen to keep control of interest rates.

This sledgehammer-to-crack-a-nut approach was responsible for the so-called two-tier economy and the negative equity of the late 1980s and early 1990s. When rates rose sharply to "protect the pound", mortgage financing costs nearly doubled and people posted their door keys through building society letter boxes. This is not another alarmist piece about a housing crash. At current rates, housing is affordable. The problem is when short-term rates go up it's not the housing market that suffers. It's the rest of the economy.

Of course, since Brown ceded control of interest rates in 1997 he has enjoyed a free ride. Rates have basically halved to their current level of 3.5 per cent. Total mortgage debt outstanding in Britain is now around £650bn. This debt is almost exactly the same as the £680bn of personal consumers' expenditure, and given the non-discretionary nature of mortgages (ie if you don't pay it you lose your house) we can reasonably suppose that a 1 per cent point rise in funding costs will lead to an equivalent reduction in consumption. To put that in context, that's equivalent to 2p on the basic rate. Add that to the tax increases already in the pipeline - including council taxes - and you can see Brown's dilemma. The real impact of his stealth taxes has so far been obscured by a stealth tax cut. Unfortunately, this trick is over. The best we can hope for is no increase in rates.

So what can the Chancellor do? Well, his first response appears to be one aimed at removing any reason for rates to go up by adopting a more suitable inflation measure. Hence the arguments with the Governor. But this is slightly academic. The Bank is aware of these problems too, and has no desire to see a recession either, so the most likely outcome is that, by hook or by crook, rates will stay low.

Being slightly more constructive, the most sensible route, in my opinion, is to build a mortgage structure similar to that of the US. This has a number of advantages, not least that the mortgage bonds issued by the lenders act as ideal assets for long-term investors, and would undoubtedly help some of the pension fund "black holes". Brown's task force has undoubtedly looked at this issue, but the need to set up a quasi-government agency similar to America's Fannie Mae and Freddie Mac means little is likely to happen quickly. Moreover, a switch to more expensive fixed rates, while economically preferable, risks the same hit to consumption that a rise in short rates would.

There may, however, be at least a partial solution, whereby the authorities can influence an existing market trend and thus avoid the cure from killing the patient. Currently around half of all mortgages are remortgages (up from less than 20 per cent three years ago). The Treasury could "encourage" lenders to make all such loans fixed-rate; five years would be ideal, but Brown might settle for three to take him past the next election. This would not hit consumption. Since no one is obliged to remortgage, and also because the US has showed us that most remortgaging goes into paying off high-cost debt, or into other investments, it would have the additional benefit of unlocking capital from the housing sector and encouraging it to flow into the productive economy. At the same time, the Treasury could encourage the notion that equity withdrawal for debt reduction and investment is better than it is for financing a world cruise. Indeed, given that the dividend yield on the UK's biggest mortgage lender, HBOS, is over 4 per cent, and on the number three lender, Lloyds TSB, is nearly 8 per cent, you could do worse than borrow at 4 per cent and invest in the shares of some of the people lending you the money.

Mark Tinker is a director of Execution, the stockbroking firm.