Imagine, if you can bear it, that you are a first-time buyer in the UK. You go to look at a 500-square-foot box masquerading as a two-bedroom flat in an average sort of area masquerading as an up-and-coming part of London. It’s a new build — one you can just about imagine downgrading your lifestyle expectations enough to live in. The problem is that you can’t quite afford it. The good news is that your Chancellor is behind you on this one. With you all the way. George Osborne really wants you to be able to buy a house. So here’s the question. Would you like him to help you do that by interfering with the market to ensure that you are offered a long-term loan you wouldn’t normally have been able to get? Or would you prefer that he didn’t interfere with the market at all, but prices fell to a level, relative to your income, that you could actually afford, and you got yourself a mortgage you could also actually afford on your own merits? I’d go for the latter and I rather imagine most first-time buyers would too. Sadly it isn’t an offer Osborne is planning to make — for the next couple of years at least.
Look at a long-term chart of UK house prices and you will see immediately what I mean. Houses have long cost, on average, just over 3.5 times the average salary. In previous booms, the multiple has risen to well over four times earnings, before reverting. Booms would be followed by busts and prices would crash before calming. Not this time. The graph shows houses soaring to six times earnings in 2007. Then there is an initial sharp fall in the ratio to just over five times followed by… nothing. Instead of continuing to fall, average national house prices have stayed at just over five times the average annual salary. Firmly within bubble territory.
Most people will tell you that this is down to the huge demand in the UK for houses. We have a small island and a growing population, they will say, so house prices can’t ever really fall much. This is nonsense. The reason, and the only reason, that house prices have not collapsed in Britain as they have in, say, the US and Ireland is because the government has not allowed them to. Our base bank rate is the lowest it has been since 1694. This has brought mortgage rates down substantially.
On top of that, just to be sure, pressure has been put on the banks to hold off on repossessions. So while default rates look lower than usual in this rather deformed cycle, James Ferguson of MacroStrategy Partners calculates that in the first part of the crisis alone some 700,000 people were moved from repayment mortgages to interest-only mortgages. This is strange, given that interest-only mortgages were being pulled from the wider market. The Financial Services Authority also estimates that around 8 per cent of households were some kind of forbearance. In a normal world all these people would have been defaulters.
Next up was Funding for Lending, another Osborne scheme that was supposed to pump money into the banks in exchange for encouraging them to lend across the economy. That hasn’t done much for small companies, but it has so far done wonders for mortgage rates (banks have to hold much less capital against securitised loans such as mortgages than they do against loans to businesses). When the scheme kicked off, the cost of a two-year fixed mortgage at 90 per cent of the value plunged from 6 per cent to more like 4.5 per cent. It’s impressive stuff — assuming you think that keeping house prices up is the most important economic policy a country can have. But it doesn’t end there. Just in case there was anyone in the country who felt they might be deprived of the opportunity to spend their life in hock to a house, the state has introduced a variety of schemes to encourage them to overpay for property while simultaneously subsidising the housebuilders (win win!).
The latest is the one that worries even the king of stimulus himself, Sir Mervyn King. It’s called Help To Buy, Osborne’s latest market-distorting scheme that effectively forces the already overcommitted taxpayer to underwrite £12 billion of mortgage lending to people who haven’t got an adequate deposit of their own, or who lack the income to have a go at producing one and who therefore shouldn’t really qualify for a mortgage at all.
Still, however Sir Mervyn feels about it, most people think the scheme will work as long as borrowers are persuaded that it is possible for house prices to keep rising — as they usually do. The Centre for Economics and Business Research predicts that prices will surpass their pre-crisis peak next year, while Knight Frank has just put out a survey noting that Londoners’ expectations of the value of their houses have hit a record high. Even this is unlikely to be the end of it: as one enthusiastic building society chief keen on ‘even more initiatives’ wrote last week, ‘There’s no shortage of ways government could step in.’
It all sounds so stupid, doesn’t it? Why would you want to obstruct so completely the free operation of a vital market? It comes down to what Sir Mervyn calls the paradox of policy, whereby ‘policy measures that are desirable in the short term appear diametrically opposite to those needed in the long term.’ We need to move away from attempting to create an economic recovery out of consumption, and work on increasing investment in productive areas. Ideally, by cutting our debt and pushing up exports. But until that happens we must work to avoid total misery by supporting the bits of the economy we used to rely on — hence the low interest rates designed to save our banks (which couldn’t cope with a property crash and need to rebuild their balance sheets) and stop consumption collapsing (would you be able to afford to go out to dinner if your mortgage rate was 8 per cent?).
But it isn’t as easy as it sounds. The UK economy is showing almost no signs of rebalancing. Given our huge debt and ageing population, it seems highly unlikely that the economy will return to what we once perceived as ‘normal’ growth levels in the near future.
How does it all end for our ongoing house-price bubble? There are three possibilities. The first is a semi-miracle whereby, somehow, wages rise to the extent that house prices no longer look crazy. Unlikely, but not impossible. The second is OK too — we carry on as we are, and house prices freeze until the rest of the economy has caught up with them. The third is that prices go up for a few years as the state throws every policy instrument it can at housing, but that the market eventually reasserts itself. You can argue that house prices are fair, in that mortgage payments as a percentage of average incomes aren’t out of line with historical norms. This is entirely true. But it is also an argument devoid of common sense, for the simple reason that interest rates (and hence mortgage rates) are out of line with historical norms.
Since 1950, the Bank of England base rate — against which most mortgages are set — has been 6.9 per cent on average. But when it rises, it tends to go up very quickly. It is usually connected to inflation, but above it. It climbed from 5 per cent in late 1977 to 14 per cent in early 1979, a near-tripling in not much more than a year. Now think about the bank rate today: it is well below the rate of inflation. If the base rate tripled, it would still be only 1.5 per cent. But if it were normal relative to inflation, it would be around 5 per cent. Then mortgage rates would be at least 7 per cent. Could you pay your bills then? Could your neighbour? And what about all those people who had to be shifted to interest-only mortgages because they couldn’t afford normal ones, even with the bank rate at its lowest level for over 300 years? Quite.
The idea that the UK housing market should in any way be driven by market forces was abandoned long ago — anyone who has bought a house in the last five years, or indeed who is paying a mortgage, has already in effect been helped to buy. If anyone other than the government manipulated a market to this extent, it would be illegal. And anyone scammed into buying a house at today’s prices — and in particular a fast-depreciating new build with a locked-in mortgage lender — would one day be able to sue for hundreds of thousands of pounds.
They’d probably want to sue in about five years — once they had started paying ‘loan fees’ linked to RPI inflation on the bit of the mortgage the government guaranteed. Also standing in the queue for compensation would be the many thousands who, regardless of the endless help offered, have stayed locked out of the housing market thanks to stupidly high state-manipulated prices. But because it is the government messing with the market, it doesn’t fall into the same camp as, say, Libor or oil-price fiddling. And all those people stuck and soon-to-be stuck with unnecessary debt have no comeback.
They aren’t, of course, the only losers from the ongoing policy of overstimulus. Savers, annuity purchasers and anyone on any kind of fixed income are hurting too. But homeowners are the only ones whom Osborne, in his apparent conviction that the answer to every problem is higher house prices, is quite so directly herding towards disaster.
Merryn Somerset Webb is editor in chief of MoneyWeek.
This article first appeared in the print edition of The Spectator magazine, dated 25 May 2013