Stephen King: Is this just a blot on property horizon, or a turning point?

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The Independent Online

I was talking to an estate agent the other day who assured me that houses in my local area were still selling at a brisk pace. This act of bravado was all the more impressive for being completely at variance with the facts. I've been leafing through the local property papers on a regular basis, trying to gauge the neighbourhood mood, and it seems to me that the housing market in my area has become distinctly chilly.

A few months ago, most houses were snapped up before the ink had dried on the property bulletins estate agents insist on putting through my letterbox. Now, though, the same old houses appear week after week. Maybe the sellers are too greedy, demanding silly prices for uninspiring properties. Perhaps, instead, there's simply a shortage of buyers. Either way, homes no longer seem to be selling like hot cakes.

Admittedly, the UK market has been subject to a few unexpected shocks in recent weeks, not least the Northern Rock fiasco. Earlier interest rate increases from the Bank of England also haven't helped. Estate agents are no doubt hoping we're seeing no more than a pause for breath, an insignificant hiatus before residential property prices in the UK resume their relentless march upwards. After all, the UK went through a similar experience in 2005.

A period of weakness led to a single rate cut from the Bank of England which, like a dose of Viagra, removed at a stroke the housing market's earlier flaccid performance.

Maybe the estate agents' hopes are justified. I'm not so sure. The UK's property boom has been part of a global trend towards ever higher residential property prices. Yet we've already learnt from the US experience that, should things go wrong, the property market can become disturbingly unhinged. And there's now the risk of a global crisis which individual central banks may find difficult to contain through changes in interest rates alone.

In America's case, the housing downswing has taken quite a while to trigger broader economic reverberations.

The first people to be hit were the homebuilders, who failed to recognise that, eventually, there simply would be too many homes to go round. Then the ultimate lenders were hit. Wherever they were – across countries, geographies and time zones – financial institutions discovered too late that they'd lent too much money to the wrong kinds of people.

Only now, as these very same lenders exercise some belated restraint, are US households likely to experience the chill winds of an economic downswing.

The UK's story is rather different. Whereas the US suffered from too much homebuilding, the UK has generally suffered from too little. There's too little land and, perhaps, too much regulation. Even so, other features of the UK property market are on a par with developments in the US. House prices have risen rapidly.

They're now remarkably high relative to average annual incomes. The buy-to-let market has boomed even though rental yields are very low (suggesting that people have invested not for income but, rather, for capital gain). Lending standards have been remarkably relaxed. Does all this mean that the UK, like the US before it, will face some kind of housing implosion?

My trusty estate agent had the answer to this particular concern. In his view, people always have to buy houses. There are, apparently, many families hoping to move to somewhere a bit bigger and a tad more chichi. There is, though, one major problem with his argument. People can only up-size if they can sell their existing property. While there are plenty brave enough (or foolhardy enough?) to take out bridging loans, the housing market as a whole depends not on what we'd like to own (most of us, I'm sure, dream of many bedrooms and multiple acreage) but, rather, on what we can afford to own. That, in turn, depends on credit availability within the housing market. Credit availability, though, may be beginning to dry up.

Earlier in the year, the Bank of England was hugely frustrated because, despite persistent interest rate increases and credible warnings of more to come, buying a house was a relatively straightforward task. These frustrations, however, were not confined to the Bank of England.

Other central banks, including the European Central Bank and the Reserve Banks of Australia and New Zealand, had been pushing rates higher yet, all over the world, house prices kept rising rapidly. There are one or two exceptions – Germany and Japan spring to mind – but most major countries have seen very buoyant property markets, fuelled by ever-higher mortgage debt. Some argue that the global residential property bubble has been confined mostly to the so-called Anglo-Saxon countries but there are plenty of other examples including, most obviously, Spain.

In all cases, domestic housing markets seemed impervious to changes in monetary policy. Why was this? Why had central banks seemingly lost control? Let me offer five, mutually consistent, explanations.

First, housing became an attractive investment when stocks fell out of favour following the 2000-1 stock market crash.

Second, the Federal Reserve, in particular, encouraged housing activity in the early years of the decade because it feared a corporate-led recession which, given Japan's experience in the 1990s, threatened to turn into a depression.

Third, interest rates of all maturities ended up lower than expected, largely reflecting heavy investments in government paper by emerging market central banks, whose foreign exchange reserves were overflowing (so-called carry trades, where people borrowed cheaply in yen for a higher return elsewhere were also important in this regard).

Fourth, low interest rates spawned a "hunt for yield" by private investors who, increasingly, were tempted to put their money in exotic structured products – often ultimately linked to housing assets – whose underlying worth was unclear.

Fifth, the growth of these structured products led to an increasing gulf between underlying borrowers and investors, a gulf that domestic central banks and regulators were unable to bridge. The associated information lacuna led, in turn, to a systemic mis-pricing of risk.

That, though, was then. Lenders have now woken up to the problem, recognising that their investments had been far too risky. As they tighten the lending screws, the global housing market may have reached a turning point.

Over the last couple of years, a combination of financial innovation and carry trades undermined the monetary sovereignty of individual central banks, breaking the link between short-term interest rates and effervescent housing markets. This argument, though, cuts both ways. Having been through a time of plenty, perhaps we're now heading towards a period of austerity.

Yes, people want to move house. And, yes, some families get bigger and need more space. But house prices ultimately must respond to the laws of supply and demand. And if demand falls away as a result of tighter lending standards, it's more than likely that sales will drop and prices will fall.

So far, the data in the UK and elsewhere is not convincing enough to tell us we've reached that point (although the evidence from the Royal Institution of Chartered Surveyors is pointing in only one direction). However, the risks of a housing slump are surely greater now than they've been in years.

Stephen King is managing director of economics at HSBC