Dangers behind the good news on house prices

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The Independent Online
Every few days some new data emerges showing the two completely different pictures of the inflationary outlook that are now facing the UK. On the one hand current inflation - that is the price of goods and services, whether measured at a wholesale or a retail level - is flat or declining. On the other hand asset inflation - measured by house prices, commercial property or share prices - is looking perky.

Yesterday the news was flat wholesale prices, which dipped from 2.5 per cent to 2.2 per cent in July. The markets were taking this to suggest that the next set of retail prices would also be encouraging. This is going to go on. We are going to have good news on inflation at both the retail and the wholesale level for some months more. Virtually all the forecasters consistently over-estimated the level of inflation for the last three years, and there is no reason to suppose that there is any change in sight.

In fact the figures will soon look even better. Over the last 18 months the headline rate of inflation has fallen steadily, as the left-hand graph shows. Though so far the more representative measures, excluding mortgage interest payments and VAT and other taxes, have failed to make a make a corresponding decline, expect these too to come down in the coming months.

But this run of good news on current inflation will be set against a parallel string of stories about rising house prices. By the end of this year some forecasters, most notably Stephen Bell at Deutsche Morgan Grenfell, reckon that house price inflation will be running at 8 per cent a year. As he argued at the weekend in an article in the Independent on Sunday, there is more to come: by the end of next year price increases could be running at 10 per cent in the South-east. The sudden spurt of house prices this year is shown in the right-hand graph.

That is only one form of asset price; UK share prices this year (in contrast to those on Wall Street and most Continental markets) have not performed particularly well. But house prices in the UK are a particularly important component of personal wealth, and in any case if one takes a three-year view of UK share prices there has been considerable asset inflation there too.

This divergent movement of the two sorts of price raises a string of questions. The first is: does it matter? An obvious reason why it might is the danger that asset price inflation will leak across to create current inflation. In the UK in the past it has done so, with the main mechanism being the additional demand created by strong house prices: partly equity take-out, partly purchase of consumer durables, partly simply the confidence that a rise in wealth creates. So asset inflation adds to demand, which in turn puts pressure on prices.

Up to now virtually all the discussion about the dangers of asset inflation has been in these terms: leakage from one, supposedly benign form of inflation to another more malignant manifestation.

A less obvious reason why it might matter is the social and commercial implications of a rise in asset prices. At a personal level, asset price inflation gives resources to the "haves" at the expense of the "have nots" - or maybe, given the prospect of inheritance, the "have not yets". Rising house prices obviously benefit those who have already bought houses at the expense of first-time buyers. But they also have an inter-generational effect: they benefit the old at the expense of the young. Higher pensions (resulting from better performance of pension fund assets) similarly are an inter-generational transfer, from young to old, from workers to non- workers.

A further effect of a rise in asset values is that, to some extent at least, this process adds to industrial costs, and benefits established companies at the expense of new ones. If office and industrial land costs rise, it is the fattest companies which benefit most - those with spare assets they can sell. So there is not just an inter-generational transfer between people; there is also an inter-generational transfer between companies, and arguably at least, a transfer from efficient companies (i.e. those without spare assets) to less efficient ones.

Even worse than this, asset inflation may encourage poor investment decisions. We still think of investment as money put into physical entities: factories, office blocks, plant and machinery, computer systems. We do not think of it as training of workers, improving the quality of service, or building a loyal customer base. But in the long-term prosperity of many businesses, investment in intangibles like this is becoming much more important than building a new plant. The trouble with asset inflation is that it encourages investment in the wrong sort of things: office blocks which the investor hopes will go up in value rather than improved customer relations which will, more slowly, increase profits.

The argument which is seldom made is the case for lower asset prices. Virtually all the discussion about the fall in house prices which took place in the UK has been in terms of the impact on those with negative equity. There has been far less attention paid to the benefit to young people who have found new homes more affordable than for a generation. Virtually all the discussion about the collapse of commercial property values has been on the negative impact on the lending banks, rather than the creation of cheap factory and office accommodation for new businesses - not that the banks with negative equity on their investments have attracted as much sympathy as homeowners in the same plight.

But in any real sense asset inflation is almost as corrosive as current inflation. You can see this best by looking at societies which have experienced asset booms, the best example perhaps being Japan. There, the juxtaposition of zero current inflation and inflated property prices has greatly prolonged the recession: only now, four or five years after the rest of the world, is Japan back in growth.

To say all this is not to claim that the UK faces the same scale of problem. Clearly it does not. Rather it is to say that, first, we should be just as worried about a surge in house and/or share prices as a rise in current inflation. Second, the leakage of one form of inflation into the other may be the less important facet of the problem than the distorting impact of higher asset prices. And third, asset price inflation has grave social and economic consequences which are frequently overlooked.

In the coming months there will be a string of "good news" stories, particularly related to house prices. Fewer and fewer people will be in negative equity; housing activity will rise; people will feel richer. There will be very few stories about the effect rising house prices are having on people not yet on the housing ladder, and fewer still about the inefficiencies as companies invest in physical assets rather than human ones. Welcome the good news on the retail price index, while it lasts; but take with a pinch of salt any "good" news on the price of property, and see just who is benefiting and who is being disadvantaged by it.