The great lesson of the financial crisis is that free-market principles are insufficient when the property market is booming. For it was the excesses of the real estate market in the major economies, particularly the United States but also here and in the rest of Europe, that gave us “sub-prime”, toxic debt and all that followed, eventually busting virtually every major bank in the Western world. “Never again,” everyone said.
Not least the Bank of England, which must bear some part of the blame for what went wrong last time round. The Bank’s current caution is justified, and not simply because it is wary of being discovered “asleep at the wheel” twice inside a decade. The Bank is acting to raise loan-to-value ratios and imposing an interest rate “stress test”, under newly acquired powers. It is right to do so – but not because the Bank is the right body to manage the UK’s property market, something of a fool’s errand for a central bank. The point of policy is to prevent damage to the financial system and the wider economy when a bubble bursts. A vigorous housing market underpinned by rising incomes and without reckless lending by financial institutions is something the Bank can and should leave well alone, and let property prices go where they will. That is not the case today.
The market is not supported by strong growth in wages, which have only just edged ahead of inflation. And, while the Great Recession appears to be over, and notwithstanding the return of parts of Lloyds TSB to the private sector, our banks and building societies are still recovering the strength they lost in the crash. They are ill-prepared for any fresh financial onslaught from a property market in meltdown.
That is the direct risk to financial stability. An indirect one arises if households become badly overstretched as interest rates return to normality. That is why it is prudent to ask the banks to make sure borrowers can cope with interest rates at higher levels. While the recent signals on how soon the bank rate will go up have been confusing, the trend is not in doubt.
A return to normality will be something of a squeeze for the most heavily indebted households. Now consider the effect of some unpredictable external shock such as a hike in oil prices, for example. If that happens, unemployment rises and interest rates have to be set high to constrain inflation, tipping many households into negative equity, and leaving them unable to service their home loans, as happened in the early 1990s. That, in turn, would destabilise the banks. It is prudent to make sure that new borrowers can cope with the bad times as well as the good.
Before the invention of these “macro prudential” tools, to use the jargon, the Bank would have had to use interest rates to do everything. Fortunately the Bank can now take action on the housing market and the threat it poses to financial stability, at the same time as it keeps rates at a relatively low level to boost the recovery in the real economy. It has the tools; let us hope the Bank can finish the job.