Hamish McRae: The dangers of the credit boom are not as great as they were in the late 1980s

People are richer than they were in the early 1990s, roughly 50 per cent richer. Their incomes and their wealth have gone up
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The Independent Online

So Nationwide says the housing boom is over. Well I think we all knew that, or at least we knew the boom could not continue at the pace it had reached in the past couple of years. The question, of course, is what next?

So Nationwide says the housing boom is over. Well I think we all knew that, or at least we knew the boom could not continue at the pace it had reached in the past couple of years. The question, of course, is what next?

Actually Nationwide reported a continuing overall rise in house prices in August. It is just that at 0.1 per cent the rise was the smallest one-month increase since October 2001, when activity was suppressed by the terrorist attacks in the US the month before. House prices are still up year-on-year by nearly 19 per cent. But the point is right. As anyone with any knowledge of markets will testify, the mood of a market that is as likely to go down as up is quite different from one where there is only one way to go. Anecdotally the housing market has changed sharply: people who do need to sell are grabbing cash offers rather than waiting around for something better.

If stagnation were to turn into actual declines, then there is little doubt that consumption would be hit, for people have borrowed against their housing wealth to support spending. The important thing to appreciate, though, is that what happens to the housing market is as much a function of what happens to the economy as the other way round. If general growth continues and if people keep their jobs, they will have to live somewhere near those jobs. They will need homes. They will have to buy them. And they will have to borrow to buy them.

That leads to one of the really crucial issues: are people dangerously over-borrowed or is their willingness to borrow a sign of confidence in the economy?

The charts help put this conundrum into perspective. If you take the headline figure for personal borrowing of £1,000bn, it looks a bit scary. If you look at borrowing in relation to after-tax income, it is bit disturbing too. The top right-hand graph shows how there has been a sudden surge in borrowing since 1999, particularly on mortgages. The previous credit boom of the late 1980s ended in tears, with repossessions, negative equity, personal bankruptcies and so on. This one starts from a higher base, so presumably the danger is even greater.

Well, not really. For a start we now have an independent monetary policy, whereas in the early 1990s we were part of the European Exchange Rate Mechanism and found our interest rates pulled up by the circumstances of German reunification.

Equally important, people are richer than they were in the early 1990s, roughly 50 per cent richer. Their incomes have gone up and their wealth has gone up. If you look at people's net worth in relation to their income it is pretty much the same as it was at the end of the 1990s and in 2000 (second-from-top graph). The main recent shift has been that housing wealth has just about overtaken financial wealth. The fall in share prices has been largely offset by the rise in house prices. So there is nothing abnormal on that measure.

What about the oft-watched ratio of house prices to average household incomes? The bottom graph on the right-hand side shows three measures of this ratio, one from Nationwide, one from Halifax and one from the Office of the Deputy Prime Minister. I'm not sure why "Two Jags" has to have his own index of house prices, but on the ODPM calculations, prices are now more than five times earnings. Even on the other two measures the ratio is about 4.5 to 1 - similar to the 1988 peak. It may be that the dip of house prices during the mid-1990s was an aberration, but this still looks uncomfortably high.

But maybe in a world of low inflation and low interest rates, high debt will become the norm. The bottom right-hand graph shows interest payments in relation to disposable income. It only goes up to the third quarter of last year so it does not show the impact of the current interest rate tightening cycle. But even with rates going to, say, 5.25 per cent, the pressure would be nowhere near that of the last peak in rates. Many people have fixed their mortgage rates for the time being. So while some individuals will be under pressure, for the majority rates not only have to go up but also stay up for a while before there is likely to be serious trouble.

Barclays Capital, which pulled together the graphs here earlier this year, reckons that the case for pessimism is overdone. It reckoned that rates could be tightened to, say, 5 per cent without severely hitting consumption or the housing market. But the Bank of England's Monetary Policy Committee has to be careful.

That surely it will be. We can assume from what the Governor has said that it is desperate to bring the housing boom to an end without tipping it into a slump. It is tricky to do this: an inevitable balancing act. What it may well have done now is to cap the boom. If so that will be a relief. Once the upward movement is stopped and clearly stopped, the Bank will start to have scope to ease back on interest rates.

That, I suspect, it will have to do next year. There are two reasons for this.

One is that global growth, currently robust, will be much weaker a year from now. You can already see softness creeping in. Early warning measures of slowing world trade, such as the volume of Japanese exports, have fallen back. The forecasters, having been a bit too pessimistic about this year, are shading back their expectations for next.

The other will be that the fiscal stimulus that the UK economy has received over the past three years will be over. Thew deficit has swung from surplus to a deficit now of more than 3 per cent of GDP, adding about 1 per cent annually to demand. That deficit is not going to be allowed to grow much; indeed it will have to be reined back. So instead of being a positive influence, fiscal policy will become a negative one.

The result will be that the Bank will have the opportunity and the need to offset the tighter fiscal policy with a looser monetary one. If house prices were still whizzing away they would not have that opportunity.

So what next? Well here are some ideas - ideas rather than confident predictions. Somewhat slower economic growth next year, here and internationally. Another rise in interest rates here, maybe two more. A peak in rates next spring, with the first fall next autumn. House prices on a plateau, with some falls in areas of weak demand, but no collapse akin to the falls of 1990-92.

If that sounds too mild, too complacent even, there is a further twist. That plateau might last a long time, maybe the best part of decade, while wages catch up and bring the earnings/house price ratio back to below four.