Economic View: Bricks and mortar falters

What happens when the housing bubble bursts?

When, not if? Yup. You can argue about the scale of the bubble, claiming that proportionate to personal incomes it is not quite as high as at the height of the 1980s boom. You can believe that it will deflate quite slowly, without as much damage either to the economy or to family finances as was inflicted by the slump of the early 1990s. And you can claim with justification that the problem is principally one of London and the South-east, rather than the country as a whole. But it is a bubble and it will burst.

When, not if? Yup. You can argue about the scale of the bubble, claiming that proportionate to personal incomes it is not quite as high as at the height of the 1980s boom. You can believe that it will deflate quite slowly, without as much damage either to the economy or to family finances as was inflicted by the slump of the early 1990s. And you can claim with justification that the problem is principally one of London and the South-east, rather than the country as a whole. But it is a bubble and it will burst.

The usual measure of house prices is to relate them to personal income. The figures shift about a bit depending on whether you take pre-tax or post-tax income and whether it is family income or main earner. They also are distorted by the London effect. Nevertheless, for most of the post-war period they seem to have settled in a band between three and three- and-a-half times average salaries. They went to five in the late 1980s boom, dipped below three in the early 1990s and are around four now. So they look high, but outside London not outrageously so.

Whether houses stay towards the top of the post-war band or languish towards the bottom will depend on a number of factors. Perhaps the most important single one is whether people continue to regard them as investments as well as places to live. So let's start with that.

Right now there is no contest: shares are plunging but residential property (with the exception of the top end of the market) is still climbing. But look at the graph on the left. For most of the 1990s it was the other way round. The ideal financial policy would have been to hold shares from 1991 through to 2000, then sell the shares and buy the property. Despite the recent crash in shares, the worst since the 1970s, the overall return over the past 11 years has been much the same. Who knows? It might actually be right now to sell the property and buy the shares back.

At some stage, particularly if we have a period of low or zero inflation, it may well turn out to be better to hold either shares or government securities instead of houses.

This may be particularly true in parts of the country where growth is slow. Prices in the North-east and parts of Scotland have lagged behind the rest of the country for the past decade.

The reverse has happened in London for two reasons. One is government planning policy, which has restricted the supply of land for building with the result that completions are close to an all-time low. That was not the aim of policy; just the usual law of unintended consequences when governments intervene in the market.

The other has been the boom in job creation. As you can see from the second graph, London has streaked ahead in job creation and these people are well paid: in the Square Mile the average salary, average mind you, is £60,000 a year – and the workers have to live somewhere. So prices have shot up. But now the London economy has taken a hit: bonuses are down and the place is losing jobs. So already the top of the market has fallen, rents are declining and the market as a whole may fall if many of the homes bought to rent are suddenly put on to the market.

But wait a moment: why should that happen if interest rates do not rise? In the early 1990s it was the surge in rates associated with membership of the ERM that made the property crash much worse than it would otherwise have been. Interest rates are not going to rise much now, surely?

I think that is right, but then inflation is not going to rise much either. If general inflation is not going to rise then prices will simply become a function of supply and demand. Demand will be underpinned in regions where the economy is strong; the South-east will probably be all right in the end. But if planning controls are eased and supply is increased, then even a strong economy will not hold up prices.

Besides, people have been using the equity in their homes to support spending. Look at the next graph, which shows real disposable income – how much we have to spend. This has been growing very strongly until the last few months: the grey bars. But more recently, people have been topping up their income by borrowing more against the value of their homes – what is dubbed equity withdrawal. So the black bars, real income plus equity withdrawal, are higher than the grey bars. Sooner or later that has to stop.

It would stop if house prices were to fall because we would become much more worried about our borrowing. If you look at household borrowing as a percentage of GDP (final graph, top line), you can see there was a long flat period in the early 1990s when borrowings did not rise. That was the period when house prices were either falling or stagnant and people did not feel confident enough to increase their debt. Now it has shot up again and is even higher than debt in the US (grey line).

We have been in a virtuous circle. Higher economic activity has meant more jobs, which has meant more people buying homes, which has meant higher house prices, which has meant people can borrow more, which has meant more spending and hence a still-strong economy.

This can go on a long time after people start to worry, just as the equity boom carried on a year or two longer than many of us expected. But it does not go on for ever and the virtuous upward circle can become a vicious downward spiral.

Ultimately things will adjust; they always do. That is what markets are for. I do not see catastrophe. But there will be a more difficult time when the housing bubble does burst, and we should be ready for it.