Stephen King: Increased public spending is fuelling housing boom

People can't stop talking about the housing market – one minute they are rich, the next they are poor

I've put this off for a long time but I've finally decided to bite the bullet. I'm going to write about the housing market. As a result, I'll be adding to the thousands – no, millions – of words that have already been expended on this peculiarly British topic.

The British public likes a flutter. Once upon a time, it was the Grand National or the Derby. It's now more likely to be the National Lottery or spread betting. Over the years, however, there has been one area of constant speculation. Whether they're developers or chatting at a dinner party, people can't stop talking about the residential property market. One minute, they think they're rich. The next, they're apparently poor. And so the game of housing roulette goes on.

Let's start with some facts. The rate of house-price inflation – a Halifax index shows – stood at 24.2 per cent in the year to September. This marks the highest rate of increase since shoulder pads were all the rage in the late Eighties. Prices rose by 4.3 per cent in September alone, the largest increase on record. The ratio of house prices to average earnings – regarded as a measure of housing affordability – stands at 5.5, the highest since the peak of 5.6 in 1989. Yet interest rates are a lot lower than they used to be. As a result, interest payments (including both mortgages and other payments) stand at 7 per cent of disposable income, compared with a peak of 14.3 per cent in 1990.

The simplest explanation for the persistent strength of house prices is that, with low rates of interest, housing ismore affordable. With (mostly) fixed supply, that means prices should go up. Moreover, with some areas of the UK economy looking weak and with the global economy in a spot of bother, there appears to be no imminent prospect of a rise in interest rates. Thus, would-be purchasers can spend, and spend some more, with no need to worry too much about a repeat of the nasty early Nineties, when prices crashed.

Parts of this story are right, but I don't think that all of these parts add up particularly well. Implicit within these observations is a series of assumptions that, perhaps, should be spelt out more clearly. I'll summarise them as follows. First, only increases in interest rates are likely to cause house prices to topple over. Second, although debt levels have risen, households maintain – and will continue to maintain – both a willingness and ability to take on more debt at current interest rates. Third, the only factor to consider when borrowing funds to purchase a house is the debt service cost.

The first assumption is, of course, a throwback to the last housing bust. That was caused by higher interest rates. But it doesn't follow that higher interest rates need be the only cause of a housing bust.

Other factors could prove relevant. Companies are not exactly in the same happy state as consumers and could easily decide to pass the buck by cutting bonuses, freezing wages and making people redundant. House-price gains may also be partly related to an asset allocation switch by investors who have become increasingly disillusioned with equities. Property prices might be boosted on a short-term basis but it is difficult to imagine property and equities moving in completely different directions forever.

The second assumption is questionable. As Diane Coyle pointed out in this column on 2 September, we don't really have much of an idea about the desired level of household debt. It's a constantly moving feast, heavily influenced by financial deregulation and the extent of competition within the mortgage market.

All very true, but I think that it's possible to spot potential warning signs. The degree to which people are prepared to take on liabilities is likely to be influenced by the state of their assets. And, to the extent that their financial assets – either directly in the form of their equity ISAs or indirectly in the form of pension funds and endowment polices – have wilted rather unpleasantly, it may eventually dawn on would-be homeowners that building up stackloads of debt might not be the wisest thing to do.

Of course, as long as house prices continue to rise, debt levels can rise, which gets us back to square one – and is in danger of putting the cart before the horse. This brings me, however, to the third assumption, namely that the key influence on the decision of what to borrow rests on the debt service burden.

Ultimately, the ability to cope with debt depends on three factors. First, there's the debt service cost. Second, there's the other side of the balance sheet, namely the change in asset values. Third, there's the outlook for income levels over time. Much of the debate about housing has, of course, focused on the first and second of these three factors. But it is the third that, perhaps, deserves some more attention.

One of the key things about debt is that its value is fixed in nominal terms. Knowing this, people tend to borrow more when interest rates are low. Let's say, however, that interest rates can fall for both cyclical and structural reasons. If rates are cyclically low, it's likely to mean that growth will rebound and that incomes will be secure. If rates are structurally low – Japan is an extreme example over the last decade – it may mean that growth expectations are falling away and people's incomes may not be secure. Under this scenario, low interest rates may encourage people to borrow in the short term but they might live to regret it.

And people have really been borrowing, partly because of continued housing strength. Mortgage equity withdrawal amounted to £10.6bn in the second quarter of this year, a sign of consumer confidence but also an indication that consumers may be taking their housing wealth a little too much for granted. The problem is obvious: household liabilities may be fixed in nominal terms but household assets – including housing – are not and nor is income. And what goes up....

So is the housing market likely to topple over? John Butler, my colleague at HSBC, has identified a "bubble" element in house prices, a degree of increase that cannot be explained away by the standard economic relationships. In other words, there's a speculative element to recent gains that could easily be reversed, perhaps because of weaker consumer incomes or higher unemployment, or because of worries about the value of financial assets. Under those circumstances, the appetite for ever-increasing debt might recede relatively quickly, thereby undermining housing gains.

Against that, however, is the extent to which fiscal loosening is creating jobs and raising wages in the public sector. The irony is that expansionary fiscal policy is keeping the labour market buoyant, thereby adding a further impetus to house-price inflation. Ultimately, taxpayers might find that public spending has done more for house prices than for either health or education. The more that house prices rise, the more that public-sector workers will have to be paid. And so the housing merry-go-round keeps going.

Stephen King is managing director of economics at HSBC