Hamish McRae: House price crash across the Atlantic could give us a soaking over here too

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The Independent Online

Alan Greenspan's twice-yearly testimony to Congress is crawled over by the analysts for gems of wisdom. The markets seek any hints as to the direction and pace of interest rate changes, any nuances in the good doctor's perceptions on the US economy and, insofar as there are any, the implications for the dollar and longer-term bond yields.

And so it has been this week. The main reading of Mr Greenspan's comments seems to be that the expansion has become self-sustaining. Rising employment will boost incomes and consumer spending, and therefore it is safe for the Fed to lean against growth by increasing rates.

It may be safe to raise rates, but does he need to. Inflation? He is none too worried as the present small rise in the price of finished goods has been the result of increasing profits, not higher unit costs. Apparently profits, as a share of national income, are at a historic high. So the rise in inflation is more a short-term phenomenon than anything sinister.

The markets seemed to conclude from this that while there will indeed be rising rates, the climb will not be at all steep. Bond yields nudged up a little but, helped by some good profits figures, Wall Street recovered strongly.

But there is another way of looking at US monetary policy, one that will be familiar to anyone here in the UK. It is to look at the way that cheap money has boosted the housing market and to consider the consequences of an end to the housing boom. We have seen here how the upward nudge in rates seems to have capped the boom, though as yet without making any real dent on consumption. US homes are about as strongly rated as UK ones but the US consumer is even more highly geared than the UK one.

The first three graphs come from a new study by Capital Economics in London, which thinks that the US house price boom is set to end. The argument is that US home prices have staged the biggest continuous rise in their history, that prices will stop rising, and that there is a real risk of house price falls.

The view of the Federal Reserve Bank of New York, the primus inter pares of the various members of the Federal Reserve System, is that much of the overall rise in price can be explained by improvements to the housing stock and by the decline in nominal interest rates.

The importance of improvements may well have been overlooked. Here in Britain, if you borrow £25,000 for a loft conversion, that shows as consumer borrowing - for the statistics do not distinguish between borrowing for home improvements and borrowing for, say, a holiday. If you then sell the house for £25,000 more than it would - sans conversion - have been worth, that shows up as home inflation. So the figures tend to distort in two different ways.

But is this significant in the broader context of US prices? The Capital Economics team thinks not. It is certainly true that new US houses have become ever bigger. The regular US home is now about 2,200 square feet, about two-thirds larger than the average UK one. But Capital Economics calculates that improvements account for a very small amount of home inflation.

What about the relationship to income? There are two measures here. One is to take the ratio to disposable per capita income, which (first graph) does not look too bad. Yes, it is high relative to prices in the late 1990s but it is still lower than prices in the late 1970s. But if you look at the ratio of prices to the income of employees, or (second graph) to median household income, the picture is much more alarming. Incomes at the top in the US have risen by a huge amount, which pushes up the average income figure. The very rich, presumably, don't need to borrow to buy their homes. The median income is therefore a much better guide to the ability of the average householder to service the mortgage.

What about the argument that the low nominal rates justify higher house prices in general? Debt-servicing costs have indeed remained pretty constant for the past 25 years but they have been rising slowly, despite the downward trend in long-term rates. So, yes, debt is affordable in the sense that monthly servicing costs are more or less constant. But general inflation is very much lower than it was a generation ago. So borrowings are not being whittled away in real terms. Capital Economics assumes that house prices relative to income of employees will trend back towards their average for the last 25 years, and if the relationship between prices and income is maintained (third graph) that would suggest stagnation in prices.

That would be stagnation overall. Some places will see continued rises while others will see falls. In about a dozen states prices look especially overvalued, carrying the suggestion that the falls will be greatest here. Those states have one-third of the US population.

All very interesting, you might think, but so what? Not many Brits have houses in the US and those who do will hardly be shattered if the value falls a bit.

This link with the UK is through US consumption. That is the driver of the US economy and indeed the world economy. Americans account for about 40 per cent of world consumption. Their confidence has recovered sharply since 2001 (last graph) and on the Conference Board measure is almost as high as it was at the peak of the boom.

On the alternative University of Michigan measure the mood swings have been more muted but the basic message is the same: these people are still in spending mode.

This will not last, as consumers have to repair their balance sheets and repay debt. Merrill Lynch thinks the saving rate is set to rise, and Merrill and Lehman Brothers are worried about the possible impact of a fall in US house prices on consumption.

The key argument here is that US consumers are making borrowing decisions based on the assumption that their principal asset - their home - will continue to rise. So it is OK to borrow more. If the asset stops rising it won't be OK to borrow more. So the feed through into consumption may be sharper than people expect.

What then? Well, the US home-owners stop being the world's consumers-at-last-resort. That swiftly feeds through into Continental Europe, which has been pulled along by exports mostly to the US, and eventually here. At a consumer level, more than half the annual incremental increase last year came from the US: my back-of-an-envelope calculation suggests that two-thirds of the additional consumer demand last year was American.

This is the most important consequence of all. The US Fed has led the world in a huge experiment: several years of very cheap money - actually free money because short-term interest rates have been below the level of inflation. One key result has been a rise in the price of consumers' principal asset: their homes. That period is now coming to an end, as Dr Greenspan has acknowledged this week. So consumers will be squeezed and growth next year will come down. That will affect the whole world, not just the US. Let's hope US house prices are steady enough to permit a gradual adjustment.