Hamish McRae: It's back to the world of proper saving and borrowing for homes – and the better for it

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The Independent Online

We all knew it was going to happen but yesterday it did: an evident sudden lurch downwards in house prices. The fall of 2.5 per cent in March as recorded by the Halifax follows several months of softness in the housing market but it always takes a while for prices to respond to market forces. Not everyone has to sell and people don't like dropping their price. But eventually prices reflect supply and demand. Suddenly, there is the spectre of negative equity, that beast of the early Nineties, again stalking the land.

This fall is different in character to the falls of that era. Then, as now, it followed an extraordinary boom, with double digit rises for several years, but there the similarities stop. Some things were worse then. Then the UK was in recession, whereas now it isn't, at least not yet. Then there were sustained high interest rates associated with the need to keep sterling within the bands of the European Exchange Rate Mechanism. Now rates are low and falling – there will probably be another cut this week and further reductions later in the year.

Then unemployment was soaring, whereas now it is low, with employment at record levels. However, some things are worse now. There is a higher level of indebtedness, higher house prices relative to incomes and more of a squeeze on mortgage availability. And there are many more buy-to-let properties and some of those landlords may find themselves stretched.

Still, there are enough similarities and enough of a folk-memory of the early Nineties for the news to send a shiver through the country. Sky-high house prices have been a social disaster, pricing young people out of the market, transferring wealth to the "haves", making it impossible for lower-paid workers to live near their work and so on. But a housing crash would be a disaster too. We can see the economic, financial, social and human misery that this can cause by looking across to the United States right now.

So are we going to have a price crash, and depending on what does happen there, what are the implications for the economy as a whole?

It would be mad to try and give any definitive answer to either question. Think of all those pundits who said three years ago that prices would fall 40 per cent. Think of the mighty Halifax, who until today was predicting that house prices would not fall this year. We all get house prices wrong. But I do think there are some things that can sensibly be said about both prices and the economy as a whole. There are some things we know with reasonable certainty and we just have to be honest about what we cannot know.

We know, as a starting point, that UK house prices are very high relative to incomes by historical standards; higher in fact than at the peak of the Eighties property boom. Nationally, you would expect them to be perhaps three or four times average earnings, not over five times as they are now.

We know too that mortgage terms became unduly lax during the final years of the past boom. It cannot be sensible to lend more than 100 per cent of the value of a property. We know now that such lending practices have come to an end, with the standard loan now being for 95 per cent maximum. That would have been the normal terms for most of the post-war period and indeed before. The whole idea of a building society was that people saved in the society for their deposit and those savings financed the loans of other people who were buying. Then when your deposit was big enough, you got your mortgage. And you borrowed to buy your house; you did not borrow against the value of the house to pay for your holiday.

So the present tightening of mortgage terms is really just going back to what was normal good practice in the past. Never say never, but I expect that for a decade at least, the flow of lending will be much more disciplined than it has been for the past few years.

Put these two points together and it does seem likely that prices will adjust downwards over the next few years, falling in real terms and maybe – this is much less certain – also falling in money terms. Anyone can do the sums. If inflation averages 3 per cent a year, stable nominal house prices would mean a fall of around 15 per cent over five years, more like 30 per cent over 10. If there is a fall of, say, 5 per cent in money terms this year and next then stability thereafter, there would be a real fall of 25 per cent over five years.

You see the issue. What matters will be what happens to real house prices, prices relative to other prices and in particular prices relative to incomes. The issue is whether the necessary, and I think inevitable, downward adjustment takes place suddenly and savagely or whether we have several years of flat or flat-tish prices so that inflation and rising incomes gradually whittle down the present disparities.

If we have a crash, which I would define as a fall of more than 20 per cent over the next two years, then there is a huge problem. There would be an obvious difficulty for people with negative equity and for people who could not service their debt. There would be an even more substantial problem for the economy as a whole because that sort of hit would cut consumption and in all probability push us into recession. That is what is happening in the US.

On the other hand, if the adjustment is gradual there is no reason why we should not work our way out of the problem. That is what many families had to do in the Nineties. I have been looking at some data and house prices went negative at the end of 1989, staying more or less flat or down a little right through until the early months of 1996. So there was a period of more than six years of price stagnation.

I find it very hard to think that anything worse than that will occur this time, largely because we do now have flexibility in monetary policy. We can drop our interest rates. We can also drop sterling and in the past few months the pound has fallen by as much as it did after Black Wednesday. That all helps.

So the odds are that there will be a drawn-out adjustment over several years rather than a sudden crash. Let's hope that proves right because, for the economy as a whole, the steady state is much better than the big bang. The prospects for the economy are determined by forces other than house prices but house prices are hugely important. The problem is that we are in the early stages of some sort of global slowdown but we cannot know how long and how deep that will be.

My own view remains that this year will not be the real problem because there is still plenty of momentum behind our economy; it will be next year that is likely to be more troublesome. Both those Halifax numbers are chilling. If prices were to carry on falling at that rate, things would get very tough indeed.

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