The house price correction is happening faster than anyone expected – but is that good or bad for the economy as a whole?
Most people would instinctively think it bad. Certainly there will be more short-term damage, to the construction industry obviously but also to other activities associated with the housing market. That said, in most aspects of business life it is nearly always better to make adjustments quickly. It is better for companies facing a fall in demand to cut capacity fast; better for banks with loan losses to write of the bad debts and turn attention to new business; better for retailers with stock they can't sell to get rid of it somehow and replenish the shelves.
The template for this housing crash is the last one – that of the early 1990s. Those of us who had expected a long plateau in house prices this time, as incomes gradually caught up, look like being wrong. Last time round, the adjustment was indeed a long and drawn-out one. There were four or so years of gently falling prices then a final sudden lurch downwards. That was then followed by a period of reasonable stability before the latest housing bubble, which burst last year. As you can see from the graph, the falls are coming through fast this time. According to the Halifax, prices dipped for the fifth straight month in June. It now expects a fall from the peak of last year of 10 to 15 per cent, though other forecasts talk of slides of up to 30 per cent.
If the decline goes above 15 to 20 per cent, peak to trough, this crash will have turned out bigger than the last one. But it could also be shorter. There is a floor to prices – a level where homes become affordable again. We could be back to such a stable market in two or three years, rather than five or six, and not be in for the death-by-a-thousand-cuts that US housing is enduring. It is that drawn-up aspect to the US decline that triggered the collapse in confidence last week in Fannie Mae and Freddie Mac (the Federal National Mortgage Association and the Federal Home Mortgage Corporation), the two state-sponsored lenders. If the US government does have to rescue them, that would have huge reverberations around the world. But it would also mark a turning point in financial markets.
If the decline were to continue at the present rate, we would be back to a reasonable ratio between prices and incomes after a couple of years. You can do a back-of-an-envelope calculation. House prices are around six times earnings when they should be about four times. So they have to dip by a third in relative terms. That sounds terrible but two years of prices falling at 10 to 15 per cent coupled with two years of wages rising at 3 to 4 per cent gets you pretty much there.
Now were this to happen so suddenly, there would certainly be a huge shock. A lot of people would be in negative equity and lenders would find themselves having to shepherd weaker borrowers through a difficult time, helping those who need to move home despite their loans being larger than the value of their houses. And, as noted above, there would be a lot of damage within the housing industry.
So: plenty of disruption. But once house prices have clearly bottomed out, perhaps by the end of next year, confidence could come back quite fast. While I can't see us having another runaway boom for a long time, there are lot of people out there with cash earning interest, waiting for prices to come to a level where they can again afford the homes they would like. So by the start of 2010, we could have the sort of broad stability in the housing market that pertained from 1996 to 2001.
What are the broader implications of this for the economy? I have long argued in these columns that 2009 will be more of a worry than 2008. Even now, after all the gloom that has been washing around, the economy is still growing, albeit slowly. Employment may have stopped rising but it is very high by historical standards. Unemployment has started to creep up but so far very slowly. However, the surge in the oil price may have brought the dip forward a bit, and by the back end of this year growth could have slowed to a halt. If this house price slide really gets moving, 2009 could be a very difficult year indeed.
I think the markets have at last cottoned on to this and their somewhat belated appreciation that things won't zip out fast next year was behind the further bout of gloom that hit shares last week.
Very slow growth next year will have serious consequences for the public finances, which have been drawn up on the assumption of growth of 2.25 to 2.75 per cent in 2009. The latest forecasts coming in put it more like 0.5 per cent. If that were to happen, we would be into a deficit of £50bn or more – the sort of level that would blow the fiscal rules that Gordon Brown established to bits and hence be profoundly embarrassing for a government about to fight a general election.
On the other hand, if 2009 does look grim, prospects for 2010 could be better. That may seem a long way off right now, but if the housing slump had more or less come to an end, that would give a boost to domestic demand.
And then inflation will be back to an acceptable level. Indeed, if oil and commodity prices start coming down next year, as most people expect they will, the consumer price index could be below the central point of its target range of 2 per cent. It is a simple mathematical point that the higher the oil price this year, the greater the scope for an oil price reduction to cut inflation next year. That would clear the way for cuts in interest rates, which in turn would help steady the housing market.
You see the point: at the moment house prices are falling faster than most people expected and oil and other commodity prices are rising by more. This is speeding up the adjustment. So in the short term there is more disruption than most people – and certainly the Treasury – expected. That disruption will continue for another year or 18 months and that will be difficult.
But come 2010 you could start to see the basis for an economic recovery, with growth resuming, more affordable homes and acceptable energy prices. Unless...well, unless something else goes wrong in the meantime.
Those evil speculators aren't as deadly as we think
The surge in oil prices, as with all commodity prices, has given rise to the charge that speculators are in some measure responsible – an issue to be examined by the Treasury Select Committee this week.
They might like to recall that UK politicians blaming speculators for market decisions they don't like goes back to 1964 when George Brown, the new head of the Department of Economic Affairs, accused the "gnomes of Zurich" – the Swiss bankers – of speculating against the pound to try and drive it down. In the event, the gnomes' judgement proved right, for the pound was devalued three years later.
Nowadays the gnomes are no longer just in Zurich; they are in every big financial centre. But while many people feel distaste for these traders, it is wrong to assume that speculation can distort markets in the long-term: the only thing that can do this is something that affects supply or demand. The issue is whether markets can distort prices in the short term and speculators make profits out of those artificial swings.
There is a lot of empirical work on this which seems to suggest that it can. It is too early to do the sums but I would expect that the oil price this year rose more swiftly than it otherwise would because speculators pushed it up faster. But by doing so they may have forced people to conserve earlier than they otherwise would, and hence trim the top off the ultimate peak in the price. But when a move in the markets is resisted by the authorities, speculators can clean up.
What I find most interesting is how the collective judgement of speculators can give a feel for what the hard money thinks. The index run by the broker Tradition predicts that our house prices will go on declining until 2011 – which maybe makes the recovery in 2010 argument I have made above look a bit optimistic. And the peak-to-trough "forecast"? Between 25 and 30 per cent. But look on the right side. At least no one has suggested yet that speculators are pushing prices down faster than they would otherwise go.Reuse content