Stephen King: As safe as houses? How harsh realities are dispelling the home market myths

As safe as houses. No place like home. An Englishman's home is his castle. Our language is replete with positive references to housing. It's almost as if we're programmed to believe, from a very early age, that housing is somehow "safe".

Of course, we all need a roof over our heads and, for the homeless, life can be genuinely tragic, but I wonder whether our pre-programming sometimes goes a little too far. Houses, after all, are much more than just bricks and mortar. They involve a huge financial commitment. They bring financial novices face-to-face with complex financial transactions. And, as we're now discovering – yet again - what goes up can easily come down.

The level of misunderstanding about housing is really rather shocking. Many people believe, for example, that renting involves throwing money down the drain whereas buying via an interest-only mortgage does not. Admittedly, those who were lucky enough to buy houses which then appreciated in value did well with their interest-only mortgages, but that's only because they turned out to be lucky speculators (and they'll still have to find a way of paying off the loan). Others, who bought at the peak of the market, will be thinking very differently. For them, renting would have been the better option.

For many people, a mortgage is the mechanism by which they become part of a property-owning democracy. They don't worry too much about the small print. They like to believe –and are encouraged to do so via programmes such as Channel 4's Property Ladder – that homes somehow are automatic gen-erators of additional wealth. Borrow some more money, paint the door a new colour, add a bit of decking and the house suddenly surges a few thousand pounds in value.

The argument is, of course, mostly spurious. During the earlier boom, most houses were surging in value whether or not their doors were painted raspberry red or battleship grey. The claim that, somehow, home improvements would make people money was, in many cases, downright misleading. Perhaps, with house prices coming down so quickly, Sarah Beeny, Property Ladder's presenter, will soon be hosting "Property Snake".

It's generally true, of course, that house prices rise over time. After all, there's only a limited housing stock, largely because there's only a limited amount of land which can be developed. Economies, though, tend to grow. As technologies improve and we become more productive, so our per capita incomes rise and our spending power climbs. As a result, house prices tend to go up. It's a simple matter of limited supply and rising demand.

Knowing, though, that house prices generally rise does not make the decision to buy any easier. The charts show the relationship between per capita incomes and house prices. Both have been rising over time, a mixture of productivity growth, demographic changes and, in the 1970s, rampant inflation. However, whereas per capita incomes have seen a smooth upward trajectory, the same cannot be said about house prices. There are good times to buy houses but, equally, there are very bad times.

How to decide? It's not easy. In the mid-1970s, for example, house prices declined in real, inflation-adjusted, terms, suggesting that those who bought in 1972 or 1973 might have made a grave mistake. Certainly, those who lost their jobs in the mid-1970s might well have regretted their earlier, overly extravagant, house purchases. Others, funnily enough, did rather well.

They were bailed out by inflation. With prices and wages rising rapidly, levels of mortgage debt, in real terms, fell quickly. As a result, the burden of repaying mortgages shrank, leaving homeowners better off (and savers worse off).

Homeowners also did rather well in the 1980s. As inflation receded, it looked for a while as though house prices would make little progress. However, the 1980s were a decade of rapid financial market liberalisation, where earlier restraints on the amounts people could borrow melted away. For the first time, both banks and building soc-ieties were allowed to lend, increasing competition in the mortgage market. Suddenly, many more people could get their feet on the lower rungs of the property ladder. The ensuing surge in demand led to the creation of another property bubble.

Much the same, of course, can be said of the last few years, where the innovations associated with mortgage-backed securities, wholesale funding and other, more esoteric, areas once again created conditions of excessive competition and overly liberal lending.

Each of these episodes could easily be described as "too much of a good thing". The idea that house prices, over the long term, tend to rise gives the impression that house purchase is risk free. This simply isn't the case. We know from the experience of the mid-1970s, the late 1980s and early 1990s and, of course, from the current situation, that house prices can indeed fall, at least in real, inflation-adjusted, terms. And, when they do, the economic damage can be far-reaching.

This time around, there are at least seven reasons for concern over both the length and depth of a housing adjustment.

First, even more so than in earlier episodes, the downturn was preceded by an extraordinary period of house price in-flation. Relative to people's incomes, house prices are now ludicrously high.

Second, the remarkable surge in house prices was helped along by the availability of easy credit. Notwithstanding the recent injections of liquidity into the banking system by the Bank of England, that earlier credit flood has now turned into a drought.

Third, even if house prices decline, the chances of first-time buyers getting on to the property ladder now are low. Banks will demand more collateral which, in turn, will require first-time buyers to offer more savings. This will take time.

Fourth, as job losses begin to come through, so housing repossessions will rise. Banks will have no interest in hanging on to these properties. The resulting fire sales will drive prices down even further.

Fifth, during the boom, many people – particularly those of a certain maturity – will have regarded the capital gain on their primary residence as a wonderful tax-free addition to their pension. As this form of "automatic saving" goes into reverse, the willingness of people to consume is likely to fade (the underlying problem is that the baby boomers need to sell their properties to the next generation which, by definition, is fewer in number).

Sixth, in contrast to the 1970s, the Bank of England has an inflation target. Even though there have been a few overshoots recently, it's very unlikely that we'll see an inflationary surge that would, in real terms, reduce the debts of those who chose to borrow too much in recent years. With no inflation bailout, the housing adjustment is likely to be all the more painful.

Seventh, notwithstanding the absence of any 1970s-style inflationary surge, rising food and energy prices are reducing people's take-home pay. This reduces still further the ability of people to buy houses or, for those already on the property ladder, to service their debts.

Arguments suggesting that the value of housing can only rise and that, therefore, housing investment is always safe are both wrong and dangerous. There are lots of good reasons why, over time, house prices tend to rise. One of the most important is the appropriate assessment of risk, in particular about the degree to which people should borrow. During housing bubbles, though, people too easily forget about risk and borrow too much. As a result, prices move a long way from their long-term "fair value" trajectory, paving the way for a painful adjustment.

Unsurprisingly, the English language is rich enough to offer the appropriate expression. In 2008, the chickens are coming home to roost.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

Interesting? Click here to explore further