Let Britain’s housing bubble burst

By Martin Wolf

What has happened to British phlegm? Instead of greeting news of falling house prices and tightening lending with aplomb, people shriek that the sky is falling. Steven Crawshaw, chairman of the Council of Mortgage Lenders, warns that it is “a real possibility . . . that net lending in 2008 could reach only half last year’s level unless additional funds become available”. Smaller mortgage lenders, dependent on their ability to sell mortage-backed securities, could even be forced out of the market. In sum, the time has come for a bail-out.

I have three answers to this cacophony of special pleading: first, anybody who thinks it is a duty of the state to help keep housing expensive is crazy; second, policymakers should respond only to clear market failures; and, third, with a floating exchange rate and an independent central bank, the UK can weather the storm if it keeps its head.

It is high time the British realised a people cannot become rich by selling ever more expensive houses to one another. According to the International Monetary Fund’s latest World Economic Outlook, UK house prices are more overvalued, relative to economic fundamentals, than those of almost any other high-income country. At long last, investors in mortgage-backed securities, all too aware of what has happened in the US, have realised the dangers in the UK. They must understand that it becomes extraordinarily difficult to know what such securities are worth as soon as house prices start to fall. They must also be aware that UK house prices have risen by a good 150 per cent since 1996, in real terms. Indeed, It would take a 25 per cent fall in real prices to put them on to the 1971-2007 trend line, last hit in January 2002. Such a decline is conceivable. Prices might overshoot downwards, but they are nowhere near that position now.

Peter Spencer, chief economist of the Ernst & Young Item club, argues that the government should step in, by borrowing to fund the mortgage market. With great respect, I think this notion is mad. It is wrong for the government to fund people to purchase houses at what may well prove the beginning of a long slide in prices. It is tantamount to the financial debauching of minors. As important, if you believe, as I do, that house prices probably must fall, it is better for this adjustment to be swift than be dragged out over many years.

So should the government do nothing at all? No. Since mid-March, spreads between rates on interbank and official three-month and six-month lending have been some 20 to 25 basis points higher in the UK than in the US or eurozone. This, it is argued, reflects the illiquidity of mortgage-backed securities. Lenders, argues Mr Crawshaw, hoard cash because they are not sure whether they will be able to borrow in future.

Whatever the source of the problem, a case exists for further action by the Bank of England in its role as lender of last resort. At present, it is working, in conjunction with the Treasury, on a scheme to swap high-grade mortgage-backed securities for government debt for terms of one to three years, after a sensible “haircut”. But credit risk would still remain with the banks. This facility would be available at all times, but would be limited to securities created up to the end of last year. All that is now needed is for the Treasury to agree to create the needed gilts. The aim of this would be to remove liquidity constraints, not provide a bail-out or reopen the market in mortage-backed securities. The latter may well be gone forever, as can happen to markets in lemons.

In all, this looks sensible. If it succeeds, net mortgage lending may remain lower than before. Yet even if it were to halve, as some fear, the nominal stock of outstanding mortgage debt would grow by a bit over 4 per cent this year, or much the same rate as nominal gross domestic product. The idea that the stock should grow faster than GDP forever is nonsense. After house prices peak, I would expect the ratio to fall, not just cease rising. Those arguing for still higher growth in net mortgage lending are arguing that the government must subsidise even more house-price inflation and the lenders who have fuelled it. This is demented.

Yet, some will protest, this is a recipe for a recession. This is false. Even the IMF argues that the economy will continue to grow this year and next, at about 1.6 per cent. After 62 quarters of sustained growth, would that be a tragedy? Moreover, the real reason for slower growth is the need to hit the inflation target. The country needs lower inflation, whereupon the Bank will have room to cut interest rates.

The adjustment of the economy towards exports and away from domestic spending is now, at last, under way. Fortunately, the exchange rate is taking much of the strain. In eight months, competitiveness has improved by 16 per cent against the UK’s eurozone partners, something Spain or Italy will only achieve painfully, after years of disinflation.

A combination of close attention to the liquidity logjam and flexible monetary policy is all that is needed. It is not the government’s job to reflate house-price bubbles. It would have been a good idea if it had done more to prevent them, instead. Now it must let events undo that mistake, rather than try to compound it.