Economics: The path to stability in housing

WORRIED building society chiefs, house-builders, estate agents and even Labour politicians clamour for the Chancellor's ear: 'Please extend the stamp duty holiday'; 'Please raise mortgage interest tax relief'; 'Please help first-time buyers with their deposits'.

The housing market bust of the 1990s is of unprecedented depth in the UK. While there are sound reasons for a short-term stimulus, the nostrums proposed above are quite the wrong medicine. A demand stimulus should help to reverse the damaging long-term decline in the private rented sector (see table) - not drag even more people into owner-occupancy.

Britain's housing market has been absurdly and dangerously volatile. The booms and busts are reflected in the average house price to income ratio shown in the accompanying chart. The ratio is now again falling back to the average for the last 35 years. But the manifestations of the decline of the past three years are painful: almost 300,000 mortgage borrowers are more than six months in arrears; perhaps as many as 1.5 million have debts exceeding the value of their houses, while repossessions this year will probably not be greatly down on last year's 75,000. House-builders are in their worst slump in living memory, with liquidations at record levels (see chart) and share prices signalling no recovery.

The causes of the slump in the 1990s can be found in the reversal of many of the factors responsible for the boom in the 1980s. The interest- rate reductions from late 1986 to mid-1988 were reversed in ferocious increases that took mortgage rates from 9.5 per cent in July 1988 to 15.6 per cent for most of 1990. The strong and seemingly more secure growth of after-tax incomes in the 1980s turned out to be ill-founded, with average real personal disposable income lower than two years ago. The financial deregulation revolution of the 1980s has gone into partial reverse as mortgage lenders and insurance companies struggle to repair their asset bases.

The fraction of people in the main house-buying age groups grew strongly in the 1980s and is now beginning to fall. Households began the 1980s with fairly low debt-to-income ratios but entered the 1990s with record debt levels. Though mortgage interest rates have fallen to under 11 per cent and, for first- time buyers with jobs, houses are more affordable than for the last seven years, real interest rates - after taking account of inflation - are at record levels. Within the ERM, Britain's prospects on real interest rates look bleak, given the Bundesbank's policy of limiting credit growth. Lastly, the many unsold properties dampen prospects for an early recovery in house prices.

When, between 1986 and 1988, I tried to alert policymakers to the consequences for inflation and the balance of payments of the house price boom, the response was sceptical. Now the weakness of the housing market is widely seen as a major factor in the lack of domestic recovery in the UK. The most serious aspect is the damage done in this slump by bankruptcies, capital scrapping and the failure to invest and train. Nowhere is this worse than in the construction sector, where firms are going bust as never before. This will impair the recovery of living standards and our ability to hold down inflation when demand eventually picks up.

But how to combine a stimulus to the housing market with the long- term aim of reducing further and permanently the speculative character of the owner-occupied housing market? The answer is to eliminate the tax discrimination faced by private landlords.

Two steps are needed. First, capital gains tax for landlords should be abolished or substantially eased - by permitting the cumulation of annual CGT allowances, for example. Second, depreciation allowances against tax should be made available to landlords when the Business Expansion Scheme expires next year.

Together with the 1988 Housing Act, which abolished rent and tenure controls on new lettings, and the 'Rent-a-Room' scheme in the current Finance Bill, this would signal that there had, at last, been a sea change in the treatment of the private rented sector. This would release the supply of entrepreneurship and private capital, stimulate repair and conversion, mop up some of the stock of unsold houses and generate new demand for the building industry. Building societies would be less reluctant to become large-scale landlords. In the short run, the demand for housing would rise relative to the existing volume of transactions.

Thus, the measures proposed are likely to prevent further falls in the prices of owner-occupied housing and to stabilise the building industry. In the long run, by expanding alternatives to owner-occupation they would help to prevent the return of speculative frenzy to that market. It is not sensible for so many households to have virtually all their wealth tied up in their houses. When unemployment strikes a city or a region, loss of income and loss of job opportunities tend to coincide with a drop in housing wealth. Having too many eggs in the same basket can leave families impoverished and their ability to move impeded. Labour market flexibility and mobility will improve as the supply of rented accommodation expands.

Though the building of subsidised social housing is desperately needed, it looks as if even Sir George Young's modest target of 50,000 units per year will be a victim of public expenditure cuts. Extending the stamp duty holiday, which is due to end on 19 August or, even worse, increasing mortgage interest tax relief, is not only expensive in PSBR terms but entrenches the fiscal privileges of owner-occupiers. In contrast, relieving landlords of capital gains tax from 1992 onwards is very cheap over at least the next two to three years, since short-term capital gains, after indexation and allowances, are likely to be negligible. Furthermore, the Government saves a mortgage subsidy of pounds 800 per year for every first- time buyer who rents instead.

Capital allowances are likely to prove cheaper in generating additional rented accommodation than the Business Expansion Scheme they would replace. In the longer term, the Government can limit capital gains by timing the introduction of further counter-cyclical reform measures to the next significant upswing in house prices.

Lastly, a revitalised private rented sector might one day provide a sound justification for reducing the sensitivity of the official inflation measure, the retail price index, to mortgage interest rates. In many other countries, the private rented sector is far bigger. In Germany (see table) home-owner costs are imputed using equivalent market rents that are relatively insensitive to interest rates. The Government would like the Retail Price Index Advisory Committee to approve the removal of mortgage interest from the index. But so far, it appears unwilling to introduce the reforms that would give people real choice of tenure.

John Muellbauer is Fellow in Economics, Nuffield College, Oxford and a member of the Retail Price Index Advisory Committee

----------------------------------------------------------------- HOUSING TENURE PATTERN SINCE 1951 ----------------------------------------------------------------- Owner- Public Private rented Housing occupation % sector % (incl housing assns % associations) % 1951 30 18 52 n/a 1961 42 26 32 n/a 1971 51 31 19 n/a 1981 56 31 13 2 1991 68 22 10 3 Approximate western German equivalent 1987 42 - 58 13 (42% not subsidised) ----------------------------------------------------------------- NOTE: Income here is personal disposable income per head as measured by the Central Statistical Office. The official house price index has been adjusted for a 0.3 per cent per annum assumed quality trend and for temporary distortions resulting from changes in the mortgage market. -----------------------------------------------------------------

Christopher Huhne is on holiday

(Graph omitted)