Hamish McRae: Stable house prices are just what people need

Economic Studies
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The Independent Online

Britain is back to falling house prices again. They were, according to the Halifax, down 1.6 per cent on the year, with the decline at the end of 2010, offsetting a rise at the beginning. Forecasts for this year mostly range from flat to a further fall of about 7 per cent. In house prices at least, a double dip is very possible.

So what does this mean for the economy? Well, falling house prices are politically unpopular and for an obvious reason: if people know the price of their home has fallen they feel poorer. There is actually a bit of economic research that suggests that house prices are linked to happiness: the higher they go the happier people are. But that presumably only applies to people who already own a place; for first-time buyers, higher prices can be a source of despair.

That much is self-evident. We all know that housing performs two functions – a home is a form of consumption but it is also a store of value – and those functions are in tension. But what are the implications of this for the economy? For example, to what extent do the needs of the housing market mean that interest rates cannot be raised by much? Or might falling prices hit consumption and thereby intensify any pause in the economy this year?

What I think has happened is actually quite encouraging. The collapse of prices was halted last year. Despite the low flow of funds into new mortgages (largely because the non-British lenders withdrew from the market) there was enough of a perception around that prices would not fall much further to put a floor on the market. The quantitative easing programme probably helped too, for if you pump money into the economy it has to end up somewhere, even if it is not quite what the policymakers had in mind.

Stopping the decline was really important, for it has helped to reduce the number of repossessions and enabled lenders and borrowers alike to understand the scale of the negative equity problem. But on a long view house prices are still rather high: at or even a bit above the top end of the long-term range in relation to earnings. Prices are a little over five times earnings, whereas the long-term average is about four times earnings. That does not mean that prices have to fall by another 20 per cent to get back to normal.

There are two reasons to justify some general rise in prices: housing a growing population on limited land and a more general distrust of financial assets, as opposed to bricks and mortar. So the slope of the average earnings to house prices line could be gently up. Still, even allowing for these factors, it does mean that we need three or four years of broadly stable prices to allow rising money earnings to catch up.

We might well get that. The only way for interest rates to go is up. Money market predictions are for base rates to rise to 1 per cent by the end of this year and 2 per cent by the end of next. That would still be very low by historical standards and way below the present rate of inflation, but a rise in rates this summer, combined with the fear of more rises to come, will inevitably put a damper on house prices.

On the other hand, any significant decline in prices is liable to create demand because there are people out there with cash and who are able to take a five or 10-year view. The result, if we do indeed get a period of stability, will be a much healthier market. People will buy homes because they need to live in them, not to make a quick return.

One final question: can we have economic growth and yet have flat house prices? The answer to that is that this was exactly the combination between 1992 and 1996, as the economy recovered from the early 1990s recession and the late 1980s house-price boom and bust. During that period there was solid growth coupled with no significant change in house prices: they only took off after 1997. This suggests a positive outlook for our economic prospects, if not for the political prospects of the government of the day. Maybe the Coalition does need an uplift in the housing market after all.

Portugal's fate is not in its own hands

Encouraging news from Portugal – but not encouraging enough to avoid what has become a ritual humiliation. The Prime Minister, Jose Socrates, was fighting yesterday to avoid the fate of Greece and Ireland in having to get a bailout, ruling this out at a press conference.

"I'd like to point out," he said, "that the Portuguese government and Portugal will not ask for any aid or financial assistance for the simple reason that it is not necessary."

When a politician says something like that they usually end up with egg on their face. Portugal did beat its target of getting the budget deficit down to 7.3 per cent of GDP last year and claims it will be only 4.6 per cent of GDP this year. But the economy is shrinking and the interest rate on its long-term debt is above 7 per cent in the markets.

When Greece and Ireland experienced that sort of market movement against them they capitulated within a few days. An unnamed official at the central bank said that the country would do better to seek international help and it must be very much odds-on that this will indeed be the case.

So what are the implications of this? First, governments can run into trouble even if they have a seemingly credible path back to budget balance. Second, if you have to borrow billions from the markets what matters is what the markets think, however unpalatable their judgement. And third, once Portugal capitulates, other weak eurozone countries will be next in line, with Spain at the head of the queue.