Stephen King: Debt worries may force the Bank to prick the property bubble

Today's boom in house prices could become tomorrow's debt mountain headache

"We have got to be clear that if consumer growth continues at its recent rate, driven in part by house prices, we would have to act to moderate that. I think that is as clear a signal as I can give." Sir Edward George's comments to the Treasury Select Committee suggest that the Bank of England is finally going to act on that old bugbear of the UK economy, the "boom and bust" housing market.

Of course, the Bank of England does not want to be seen to be targeting the housing market directly. Its mandate is the control of overall inflation, not house prices alone. Yet this creates a bit of a problem. My first chart shows movements in both house price inflation and overall inflation over the past 20 years. In the 1980s, when house prices rose quickly, so too did inflation. The requirement for higher interest rates was unambiguous. This time, we've had the pick-up in house prices but there is scarcely any evidence to suggest that we are on the threshold of a major inflationary surge.

Given this, it is not good enough for the Bank to argue that interest rates have to go up to deal with the housing market directly. Rather, it has to argue that the strength of the housing market is contributing to a broader pick-up in demand that, in turn, may contribute to a possible overshoot of the 2.5 per cent inflation target. This argument can be put together in two different ways.

First, the expected slowdown in consumer spending associated with the earlier squeeze in corporate profitability has not materialised. This might not have been a problem if industry were still flat on its back but, although hardly convincing at this stage, there are the first signs of a recovery in the manufacturing sector. If the two-tier economy is becoming a one-tier economy through modest industrial recovery rather than consumer slowdown, there may be a case for tightening monetary policy.

Second, there is a direct connection between the strength of the housing market and the continued buoyancy of consumer spending. This comes through most obviously via the rapid pick-up in mortgage equity withdrawal. My second chart shows that mortgage equity withdrawal has surged in recent years, concurrent with the surge in house prices. In other words, consumers have been increasingly happy to use their windfall house price gains to fund a surge in consumer spending over and above what consumers have received in the form of higher income.

On both counts, there is a possible threat to the inflation target. Yet, in neither case is there a direct relationship between the housing market and a potential inflationary threat. Nevertheless, the housing market could usefully be targeted as an intermediate objective in any pre-emptive attempt to remove the threat of inflation. After all, the housing market is one of the key routes through which interest rate changes feed through to the broader economy.

The Bank of England has other reasons, however, to be concerned about the housing market. Ultimately, consumers are borrowing against the rising value of non-productive assets. These gains may, in turn, be the result of some kind of speculative bubble – perhaps today showing itself in the "buy-to-let" market. Should these gains be built on unstable foundations, there is a significant danger that consumers end up with balance sheet positions that could ultimately be untenable. Today's house price boom could become tomorrow's debt mountain headache.

A potential debt problem should be a big worry for the Bank of England, in part because it sits uneasily with the Bank's mandate for price stability. In the past, high debt levels could be dealt with by allowing inflation to rise. Under these circumstances, the real level of debt would gradually erode away. In the inflationary 1970s, therefore, high debt levels were not at the top of the list of major threats to economic stability.

This time, debt is much more of an issue. Debt service costs are, of course, very low, the result of low interest rates. But this does not mean to say that debt levels can be completely ignored. Dealing with debt is not just an issue of the debt service costs: it is also an issue about the potential solvency of the debtor. Let's say, for example, that consumers borrow on the basis not only of current house prices but also expected future gains in house prices (a variant of the "if you don't buy today, you'll never be able to buy" argument). Under these circumstances, consumers could collectively end up with too much debt, leaving them exposed to either higher unemployment or, alternatively, to lower nominal wage growth.

Under these circumstances –– and faced with the risk of re-possession – consumers might choose to start paying off existing levels of debt. A wholesale shift in this direction would raise the saving ratio and threaten a prolonged period of sub-par economic growth. In effect, consumers tomorrow would be paying off their excesses of today.

This would create a significant problem for the Bank of England. Having boosted consumer demand over the last couple of years by encouraging consumers to take on more debt, the Monetary Policy Committee could eventually find itself powerless to act in the wake of a desire to repay debt on the back of default fears. After all, if debt levels are ultimately too high – perhaps because house prices are falling rather than rising – it will be difficult to persuade consumers to spend at any level of interest rates.

This is a variant of the liquidity trap arguments that have proved relevant for Japan over the past 12 years. With the benefit of hindsight, Japan faced two threats to its inflation objectives at the beginning of the 1990s. The first, in the short term, was an inflationary overshoot associated with the persistent strength of final demand. The second, over the medium term, was an inflationary undershoot and ultimate move into deflation associated with the debt overhang that stemmed from the rapid decline in asset prices.

At the moment, the UK has an additional option to deal with this kind of problem. Should debt levels ultimately prove to be too high, the exchange rate could be utilised as an effective means of switching the source of UK economic growth away from debt-constrained consumers towards exporters – a successful, if unintentional, strategy seen at the time of Britain's departure from the ERM in 1992. Should we join the euro over the next couple of years, this option – even as a last resort – would be lost. Under these circumstances, the UK really would struggle to deal with an excessive level of debt. Consumers might not spend. Exporters would not be able to help out. The European Central Bank would only give a marginal weight to specific UK problems.

Given these arguments, the Bank would be able to justify a rise in interest rates not just on the back of inflationary concerns in the short term, but also on the danger of debt deflation concerns over the medium term. The case for early action could also be strengthened by the concern that, in a euro world, many of the options to deal with an excessive level of consumer debt at the national level would be lost. Prevention now is a lot better than subsequent cure if the exchange rate medicine is eventually taken away.

Stephen King is managing director of economics at HSBC.