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11^th October 2015

What does past data say about the UK housing bubble?

The bad news, another 4 years

I like many commentators believe that the UK economy is dangerously reliant on the housing market for its growth and the astronomical prices in London would suggest that we are close to the bubble bursting. But also like many observers of the last bubble I was premature in predicting its demise. So rather than relying on a gut feeling I thought I would see what the available data suggest. This does indicate that we are in the mists of a bubble but on current trends it may take up to four years before it comes to an end.

Using a variety of source I have compared incomes with mortgage payments over the last few years to provide an indicator for when bubbles are forming and bursting. By taking the repayments on nation's average income and the average house price we can calculate the cost facing new buyers and in turn the sustainability of these prices. In some ways it is like the much used income house price ratio but as this does not take into account the cost of money or interest rates it becomes a rather arbitrary figure. In 1989 at the height of that bubble the ratio of income to house price was just 6 for someone on the average wage buying an average house but the mortgage repayments would have represented 100% of their income before taxes and other deductions were taken into account. Likewise in January 2008 repayments represented over 70% of average income but because mortgage rates were some 8% lower the typical income house price ratio had risen to 8.5 before the bubble burst. So what of 2015? The typical house price income ratio lies at 7.6 but only 48% of income is currently required for housing costs. The last time they were at these levels was at the end of 2003. So on the face of it with half of new buyer's income going out on housing costs we may be in the mists of a housing bubble forming but it is probably bearable at the moment. Under current trends of rising property prices and stagnating wages it could take up to four years before we reached the levels that the last bubble burst at. However when these figures are looked at a regional level a slightly different picture emerges. For London a typical new buyer would need to spend almost 90% on a mortgage compared to 84% in 2008, whereas the South East, the next expensive region sits at 66% and 78% respectively. The London housing market may be different from the rest of the country especially with the influx of foreign investors and no doubt one where many locals have already given up on. In all probability many of those London earners probably commute in. Nevertheless two thirds of one's income going out before tax or transport cost are take into account does not leave much for anything else. However like the rest of the country on present trends it will be another 3 to 4 years before we reach the tipping point.

On the face of it three years of continuous growth is not to be sniffed at but it does come with downsides not least the unevenness of the growth where affluent consumption and personalised services have grown alongside zero hour contracts and low wages. Equally important is what happens when the bubble does burst. Elsewhere in this blog I have highlighted how economic growth is linked with the interest paid on loans i.e. an increase in the money supply equals the aggregate interest generated on the commercial banks and building societies outstanding loans. And that this increase in money is similar to the growth in GDP. So the idea of the idea of growth coming from debt is the norm but bubbles are different. Generally lending to businesses produces sustainable growth but one based on increasing house prices can only grow while those prices themselves increase. When house prices become unaffordable the increased in lending that has been growing the economy will also stop and growth will fall back accordingly. With lending on property now accounting for 65% of the whole, the pricking of the bubble today would see GDP fall instantly by two thirds. Such a shock, whilst not as bad as previous crisis's, would cause many to review their spending and no doubt this would tip the economy into a recession. It gets worst, those business that have grown on the supply of funds from ever increasing house prices will have to shrink or close and this will not just be limited to those industries related to property and construction. It will gradually impact on other business that have benefited from the move of spending from borrowers to lenders that comes from increased debt such as restaurants and other forms of affluent consumption. For any other economy such a recession could be short lived as the manufacturing sector recovers but the last/current recession suggests this will not happen in the UK. Government and central bank policies will maintain a high exchange rate for the pound which will continue to favour consumption for those with money over production, a situation that will lead to stagnation at best. What one can't predict is the reaction of the housing market; will prices plunge or drift down as it did after 2008. This will again depend on the action of government. If they put measures in place to guard against repossession and maintain low interest rates the status quo will remain with house prices remaining relatively high. A big fall in prices may make housing more affordable but any longer lasting effect on the recovery may well be marginal as the UK has its continuing fixation with property as the only reliable form of protecting one living standards. One would have thought that within a few years of a major housing bubble people would be wary of another one but here we are again. On the basis of the last/current recession one would expect next recession to last at least another four years before property price increases returns as a driver for growth. It may even be longer as the low wage culture will be even more entrenched and the change in demographics. This will see more prosperous people retiring some of whom may have manufacturing skills that have not been learnt by younger generations. What's more there does not appear to be a future equivalent of the PPI scandal windfall that inadvertently has pumped £20 billion into the economy.

Now the caveats. The assumption is that interest rates will remain low for the foreseeable future. Of course a rate rise would change this prediction in one form or another but it seems unlikely especially with low inflation and the prospect of a global slow down. The irony is that both the low inflation and the low growth are the result of these low interest rates.That is for another blog. Another point to note is that while events like bubbles do repeat themselves the circumstances are never quite the same. It may be that today's buyers have a lower or greater propensity to debt which would shorten or length the timetable. It has to be noted that figures produced from the average income and house prices are a snapshot at the time of purchase and not a measure of overall debt and those who bought earlier will have to bear a lesser burden which is in time is also eroded by inflation. But today the impact of this mechanism is reduced by the low rate of inflation which again may speed up the bubbles demise. There again it may just reinforce the process of moving spending from borrowers to lenders. It might be that as the average price increases the numbers of borrowers who can afford them deceases to a trickle along with growth. This become especially relevant since the Bank of England has introduced a loan to property limit.

The main sources of unpredictability are events from abroad. However even here there is nothing that particularly threatens this outlook. When one looks at the house prices in the UK from 1997 to 2008 they stall around 2004 which in another time would have led to a crash, even in 2009 they were continuing to rise but it came to end with the global credit crunch. That house prices did not fall dramatically again suggests that there is resilience to it funding that is independent of the real economies. So once more with a certain irony the UK's reliance on house prices to drive growth has removed the need to find export markets and therefore it will probably be left relatively unaffected by any global slowdown. In a further twist exporting countries will be desperate to sell their goods allowing the UK to continue to live on tick. The only real danger is that the London market is so dependent on foreign investors, any act that spooks them could lead to the whole edifice coming down.