Hamish McRae: Negative equity isn't knocking at the door, but neither is the next property boom

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The Independent Online

Mortgage debt in the UK is now more than £1,000bn, according to figures last week from the Bank of England. It is a huge figure, so huge that it is hard to grasp its significance. To put it into context, our net national debt is just under £500bn and our GDP is about £1,200bn. So we have collectedly borrowed, against the value of our houses, double as much as the Government has borrowed, and nearly as much as one year's output of the economy.

You do, however, also have to put it into the context of the value of UK housing stock, which is about £3,000bn. So you could say that there is plenty of slack there. But the mortgage debt is not evenly spread and, for some people, any significant fall in house prices would mean the return of that expression of the early 1990s, "negative equity". That is, of course, when the value of a property is less than the amount of the mortgage against it.

There is a further issue. It costs about £50bn a year at present interest rates just to service the debt, a figure which you would have to double to cover the cost of paying it off over a reasonable period. This is money you have to spend. So any increase in interest rates has a direct impact on the amount of money people have left to spend on other things.

So - to put it at its simplest - there are two risks. One is that house prices fall, which would mean that some people would find they had negative equity in their homes. The other is that interest rates rise, in which case total spending is squeezed and discretionary spending particularly so.

We will come to the probability about either occurring in a moment. Meanwhile, just some more thoughts about what has been happening in recent months. You can see the pattern both of the recent surge in mortgage lending and the implications for house prices in the graphs above.

There was a sharp dip in net lending in the early part of last year but now mortgage lending has recovered to its peak levels of 2004 (left-hand graph). That dip coincided with the very flat housing market and hence an end to the double-digit increases in house prices of the late 1990s and early 2000s (right-hand graph). But as you can also see from that graph the recent surge in mortgage approvals would point to another rise in house prices.

The relationship between the two, plotted by the economics team at Barclays Capital, is not a perfect "fit" but it is good enough to suggest that house prices this year will carry on upwards pretty strongly. They certainly seem quite strong at the moment.

If that is right, in the short-term at least there should not be too many worries about the negative equity trap. But the consumption squeeze gets worse. Not only is the total debt load rising relative to incomes but the recovery of housing inflation will put pressure on the Bank of England to increase rates.

That won't happen this coming week at the Bank's next meeting of its monetary committee, nor, I would expect, during the summer. House prices are not officially something that the Bank takes into consideration when setting rates. It has to look at current inflation, and the consumer price index gives a low weight to housing costs. But it has to be concerned about financial stability and an excessive house price boom would threaten that.

To some extent house prices are contained by affordability - people cannot (or at least ought not to) take out larger mortgages than they can service. But people make mistakes. Quite reasonably, they assume that the long growth spell will continue.

The latest GDP figures, out on Friday, confirmed that there has been decent growth so far this year and in addition they revise upwards growth of recent years. This reduces the likelihood of the Bank having to cut rates in the near future, though it does not necessarily mean that it will have to increase them.

Looking ahead, though, all historical evidence suggests both that the present ratio of house prices at five times earnings is too high and that sooner or later there will be an economic slowdown, and eventually a recession.

This is not to say bad times are around the corner because I don't think they are. It is to say that the Bank cannot safely allow house prices to rise faster than incomes because, if it does, a lot of people are not going to be able to service their mortgages. People are worried at the moment about debt - and consumer debt is rising much more slowly than before. But the same caution is not being applied to housing debt.

So what will happen? There have been many predictions that there will be a housing crash and that prices are up to 40 per cent overvalued. Those predictions have been wrong, so the bears have little credibility.

What has happened here is not just a UK phenomenon, for prices have risen in most developed countries, though not in Germany and Japan. So this is pretty much a global issue.

What worries me is not that there will be a great crash but rather that there will be a long period when house prices don't move up much, if at all, and interest rates remain quite high relative to inflation. We had another rise in US rates last week, and the possibility of more to come. There is some talk of them going to 6 per cent, in an effort to curb inflation, which is causing some alarm. European rates will rise in the coming months too, though not by a huge amount.

If this is right and there is a long period of flat house prices and positive real interest rates, then people who have over-housed themselves, and over-borrowed to do so, will have made a financial error. It will be better on balance to have saved more and borrowed less. It will be the reverse of the error that people made in the past half-century who failed to borrow, buy property, and so get on to the housing ladder.

We have had two generations where the wise thing to do has been to buy more property than they need. Of course, you have to live somewhere but before the Second World War it was quite normal for people, even prosperous people, to rent instead of buying. It is still quite normal in Germany. But now both here and in the US there is an assumption that a home is something on which people will automatically make a profit. That is not a bad assumption and over the next 20 years that almost certainly may be the case. But it may not over the next five.

Meanwhile, mortgage rates may go up a bit and if they come down it won't be by much. The slog of servicing and eventually paying off that £1,000bn will be a long one.

Footballers' wives could be just what German consumption needs

Blame it on the WAGs. Rationally, the World Cup ought not to make any significant economic difference to the German economy, still less to other European economies. Rationally, you would expect an increase in spending in Germany, and elsewhere you would expect some spending to be brought forward (for example, the surge in sales of flat-screen TVs in the UK). You would also expect some distortions: more spending on partying, less perhaps on home furnishings.

But it is beginning to look as though there may be some lasting impact on the German economy and its neighbours, though not so much on the rest of the world.

This has nothing to do with who wins. Rather it has to do with the World Cup reinforcing a latent rise in consumer confidence in Germany, which is now even higher than it was during the late-1990s boom. The latest Ifo survey of retail sentiment is the highest it has been since 1992, just after reunification. Actual sales have yet to catch up, but feeling cheerful about spending is a necessary precondition to going out and doing it. If people see the WAGs - players' wives and girlfriends - hitting the shops, they think about it themselves, though maybe not the same shops.

At any rate, this rise in confidence seems to be spilling over into the Netherlands, Italy and Belgium. Capital Economics reckons that even if there are distortions, the "feel-good factor" could spread more widely across the Continent. As for Germany itself, people are beginning to talk of growth approaching 2 per cent this year. That may not sound a lot to us, but it would be well above the 1.25 per cent figure that is normally assumed to be Germany's sustainable trend growth rate.

What usually happens when there is a one-off event is that if it is just that, then there is no lasting effect. But if it supports something that would have happened anyway, then it does change the medium-term outlook. Since low domestic consumption is the key thing holding back the German economy it would be really good if this happens: good for Germany, good for Europe and indeed good for us too.