So are house prices set to crash?

People want to live in decent homes, and it is irrational to have policies that price them out of doing so

Interest rates to double? House prices to crash? The head of the Council of Mortgage Lenders put the cat among the pigeons by warning that without swift and heavy increases in interest rates house prices would spiral out of control, then crash.

Interest rates to double? House prices to crash? The head of the Council of Mortgage Lenders put the cat among the pigeons by warning that without swift and heavy increases in interest rates house prices would spiral out of control, then crash.

Scary stuff indeed. So let's start with a prediction. Interest rates will not double. They will go up, sure. My own guess would be that the Bank of England's rate, now 4.25 per cent, will reach a peak of 5.25 per cent sometime next year. But they won't double. And house prices? We'll come to that in a moment.

Interest rates won't double because they won't need to. Interest rates serve a vital purpose, helping to balance supply and demand in the economy. They are an immensely powerful weapon. Get them wrong, as we did when we were members of the European Exchange Rate Mechanism in 1992, and you cause great damage to the economy. Get them right, as broadly we have done in Britain since the Bank of England took over responsibility for setting them, in 1997, and you create the conditions for stable, low inflation growth.

But the interest rate weapon has three flaws. First, it is blunt. Because the same rate has to serve the entire country, the needs of the housing market have to be balanced against the needs of industry, of exporters, of small businesses, of farmers - of everyone else. Second, interest rates operate with a time lag. It takes something like 18 months before a change in rates, up or down, works its way right through the economy.

Third, at different times they operate in different and contradictory ways. For example, a rise in rates ought to reduce domestic demand by cutting the monthly spending power of households with mortgages. Money spent on interest is money not available to spend in the shops. But a rise in rates may also push up sterling, squeezing exporters and cutting the price of imports and raw materials. At the moment the pound is holding up well against the dollar, insulating us to some extent from the rising price of oil.

The point about this is that even if the authorities were desperate to cap the rise in house prices and wanted to use higher interest rates to do so, their power would be limited. In any case the Bank of England is legally required to hold inflation close to 2 per cent - that is, inflation of goods and services, not inflation of houses, shares and other assets. It can and does argue that inflation in asset prices will eventually feed through into inflation in current prices, but there isn't really a lot of evidence of that at the moment. Thanks to cheap imports and technological advances, the price of goods has been stable for the past five years, even falling at times. If it were not for the rising price of services, including government services, the Bank of England would be way under its target inflation rate and would have very little case for increasing rates at all.

Still, the fear that inflation in house prices might feed through more generally is cover enough for the Bank's decisions to increase rates a bit, and almost certainly a bit more. Its monetary committee has won a good reputation for judging whether to increase or cut rates, and as a result will be trusted. What it can't do is jeopardise the growth of the whole of the economy just because of one variable, however important, might become unstable.

And so to house prices: are they really so high as to have become unstable? Prices are fixed by supply and demand, and both have been rigged by successive governments. The authorities have deliberately used the planning mechanism to cut down on the supply of new homes, by restricting building on green-field sites and holding down the size of new developments. That isn't the stated aim of official policy, but has been the effect.

And they have deliberately increased demand, partly by tax advantages that still make it attractive to save for a home (including no capital gains tax on owner-occupied property), and partly by making other forms of saving less attractive. To take just one example, the raid on pension fund income by Gordon Brown will have convinced a few more people that it is safer to put money in physical assets than financial ones.

The post-war push to increase owner-occupation was not at all a bad idea: it has been the path to financial security for two-thirds of the country's population over two generations. First, a new generation of owner-occupiers was created, and then that process was extended by allowing council tenants to buy their own homes.

But the fact that most people have, up to now, done very well out of this particular form of investment has trained people to believe that it will continue to be a good investment in the future. While it may well be a perfecty decent one, over a long period, there are several reasons why it may be less good in the future than in the past.

For a start, the last 40 years have seen the greatest inflation that Britain has known for at least 750 years - there is an economic study that shows this. Houses have done well because in a time of inflation all fixed assets are likely to do well. That inflation is now almost certainly over, and we may now be slipping into a period of generally falling prices. We just don't know, but we have to acknowledge the risk. People who have bought homes simply to rent them out may not have factored this into their calculations.

Second, the various planning controls that have limited supply are unlikely to last in their present form for more than another 10 years. People want to live in decent homes, and it is irrational to have policies that try and price them out of doing so.

Third, taxation on home ownership remains quite low. Most forms of taxation are being undercut by the mobility of people and companies. But homes cannot move. Governments and local authorities hungry for revenue are likely to tax them more. If property taxes go up, people will become more chary about over-housing themselves.

Fourth, the UK has experienced a big burst of economic success over the last 25 years. As a result it is both generating big increases in wealth that are to some extent being ploughed into housing. In addition it is creating new jobs and attracting immigrants to fill them. I think and hope that this success will continue for some time, but all of us have to accept that the pace of growth may ease.

And finally, the ratio of house prices to earnings has varied between three and five times earnings for most of the post-war period. It is now at the very top of the range. If earnings go up by, say, 4 per cent a year, expect house prices, on average to go up by the same amount. But they cannot go up at double-digit rates and since they have run to the top of the range, they may have to stick around for a while until earnings catch up.

And there, surely, lies the best answer to the "will house prices crash?" question. The Bank of England has a general responsibility for the country's financial stability. It could not be in the interest of stability to create the conditions for a housing crash. Mercifully we have control of our currency and our interest rates. So there cannot be such a surge in rates as to destabilise the housing market: stability could mean some small falls, but not a crash. On the other hand, for all the reasons noted above, it is most unlikely that owner-occupation will be the great money-spinner for the new generation of home-buyers that it was for the past and present ones.