The scenario is a familiar one. House prices rising at an annual rate of 25% or more, record mortgage borrowing, surging consumer spending while manufacturing output languishes and a huge balance-of-payments deficit emerges. This was, of course, how the UK economy looked in the early months of 1988, as growth accelerated and interest rates were reduced. But 1988 was followed by 1989 and 1990, and the housing market was the principal casualty of a deep and prolonged recession.
There are obvious similarities between then and now, and pessimists are predicting a re-run of the experiences of a decade ago. Without minimising the risks of the current situation, however, the differences between the two periods are just as striking.
In the first place, at the height of the Thatcher-Lawson boom, there were 2.3 million housing transactions, which seemed to imply that people were moving about every eight years. Clearly people were not changing house that frequently. There was instead a lot of speculation in these figures, the buying and selling of property for a quick capital gain.
Today, however, with about 1.4 million transactions annually, households appear to be moving once every 10 or 11 years. and in terms of volumes, the market does not look overheated.
Secondly, the high level of debt that was built up is more “affordable” than a lower level of debt was years ago. It is true that expressed as a multiple of earnings (five times in 1988 but 5.6 times today), house prices now look more “expensive” than during the last boom. But, this larger debt is currently taking a smaller proportion of disposable incomes.
At the peak in 1990, 36% of income was needed to support mortgage repayments, whereas this is now down to 16%. This reflects the fact that interest rates have been 6% or less for over two years compared with double figures between 1988 and 1992. As long as base rates stay at current levels (and they will, given the inflation outlook), homeowners are unlikely to topple because of their debt.
Perhaps the single biggest influence on house prices and housing market activity is the third factor. Today, 200,000 new households are being formed a year. Mostly these are smaller households than the “typical” family unit, but still need to be housed. Assuming that most of the current housing stock is occupied, around 200,000 new homes are therefore needed every year. Not since 1989, however, has the number of private sector housing starts reached 170,000, and so every year the UK has added to a growing housing deficit. It is this demand on an unresponsive supply that is the primary driver of house prices and which, taken in conjunction with cheaper finance, is sustaining activity.
All of this leads to the conclusion that a repeat of the early 1990s is not on the cards. A catalyst – either rises in interest rates or unemployment – is needed for the market to turn. Between May 1988 and October 1989, base rates doubled to 15%. This hurt those who had borrowed up to their limit and sent house prices south. And any recovery was put on hold as unemployment soared to three million.
Neither of these ‘triggers’ is likely to destabilise the current housing market. At the start of this year, few forecasters expected interest rates to rise above 5%, and the average view was a rate of 4.5% at year-end.
In addition, any increase in unemployment would at worst be modest and neither of these would reverse the trend.
There should, however, be a sharp slowdown in the rate of house price increases. Future rises should be more closely aligned with income growth (ie affordability), which would bring the annual rate of house price inflation down to around 5%. The real problem for the housing market is less now than in a few years’ time. In a low-inflation environment, the debt burden is not unwound as quickly, and the issue will be how today’s heavily indebted first-time buyer can be converted into the second and third-time buyer.
However sound the market fundamentals, prices could still fall and activity slide, caused by a shift in sentiment. The psychology of a downturn should not be underestimated. If people believe there is going to be a downturn and behave as though there is going to be a downturn, there will be a downturn, regardless of what the numbers say. Given the key role the consumer has played in keeping UK growth on track, and the pivotal role the housing market has played in consumer activity, this is a risk that should not be taken lightly.