Hamish McRae: Be prepared to wait a decade for housing to become affordable again

Equity withdrawal figures show that the young who have to pay more for their homes are subsidising the lives of the old

Everyone is worried about it and it is getting worse by the day.

The issue is housing affordability. We have house prices up more than 10 per cent on the year. We have rising short-term interest rates - presumably with another increase today. We have real disposable income barely increasing, and actually, on some measures, falling for the past six months. We have a record low in household savings.

For first-time buyers things are particularly dire. The latest figures from Woolwich on mortgage affordability shows that the average amount of income spent on mortgages by people in their 20s, typically first-time buyers, reached 32.4 per cent in June. That compares with 20.1 per cent of income for all borrowers. Both figures are the highest since the research started in 2002. In London the situation is worse still, with twentysomethings paying on average 40.5 per cent of the income on their mortgage.

Meanwhile older people are still taking money out of their homes in the form of equity withdrawal. New figures show that in the first quarter of this year, home-owners took £13.2bn out of the value of their homes, equivalent to more than 6 per cent of their income. They are only able to do so, however, on the back of rising house prices.

Looked at one way, people are borrowing to support lifestyles that are more lavish than their earnings could afford. But looked at another way, the young who have to pay more for their homes are subsidising the lifestyles of the old.

The July Economic Outlook by PricewaterhouseCoopers puts some perspective on this phenomenon. It looks at trends in the economy as a whole and the extent to which disposable income is being squeezed by high interest rates and other factors. You can see the nub of the problem in the graphs.

The starting point must be that debt service costs are now higher than they were at the peak of a decade ago. Much has been made of the point that while debt is higher now, interest rates are much lower; accordingly the interest burden is still lower. That is right. The problem is that debt has to be repaid, so the total cost - interest plus some repayment - is higher. Moreover this burden, unlike that of a decade ago, cannot be cut so swiftly by falling interest rates because they cannot cut the size of the debt itself.

There is a further difference. A greater proportion of debt now is fixed, or has some fixed element. One result of this is that it takes longer for changes in rates to filter through, but when they do they come with more of a bang. Another is that when people want to refix, the rate at which they can do so will be determined by money market rates for the chosen period, rather than the very short-term rate of the Bank of England. This could be good or bad for the borrower, depending on the longer-term rates at the time, and on the time when the fix ends. At the moment it means that many borrowers face a crunch when their present fixed terms expire.

As a result of all this, the sensible expectation must be that the affordability shown on that graph will not only worsen for a while yet but also, when it does start to improve, it will improve only slowly.

Meanwhile, savings are being run down. This is not new. The next graph (produced before the very latest figures, showing a further plunge) charts the long-term trend since the early 1990s. the main point here is that there is not much slack in people's budgets to increase their spending, even if inflation eases.

Will it ease? Well, PricewaterhouseCoopers has given three different inflation scenarios, shown in the next chart. Its main one is that inflation will indeed dip down below the Bank's central rate of 2 per cent. That, however, is the Consumer Price Index of 2 per cent, which has been consistently lower than the Retail Price Index, a more accurate picture of what people have to buy. The RPI is now 4.3 per cent. If you look at what people have to pay for, things such as food, fuel and council tax, as opposed to things they might like to pay for, such as foreign holidays, even the RPI probably understates the pressure on family budgets.

But let's for the sake of argument accept the main scenario. Even then, expect interest rates to rise to 6 per cent (final graph) and stay there most of next year. That seems to be the most likely outcome. Note, by the way that in relation to inflation, rates would still be low when compared with the middle 1990s. money is still cheap by the standards of a decade ago.

The consequence of all this is not only that the combination of a very high debt burden and fairly high interest rates will continue to squeeze real incomes for the next five or more years. That is inevitable. What is harder to predict is whether housing will become more affordable as a result of a fall in prices, or at least a plateau. So many words have been written about house prices that there is not much point in adding more here. My expectation is a long plateau in prices, with falls in real terms, but we will have to see.

What is worth pointing out, however, are the social consequences of the housing boom and in particular the transfer of wealth noted above from young to old. When this happens within a family, the parents can mitigate the transfer by helping their offspring with the deposit, and maybe more, for their first home. This has now become commonplace. A rough and ready offset can be made to work. But for families where, for whatever reason, there is no family wealth to help the young, the outcome is monstrously unfair. Not all parents own homes and even if they do, not all are in a position to help their children. Socially this is a disaster.

So what will happen? Realistically I don't think we can expect much from the Government. Ideas about creating more social housing actually make matters worse. A "social" house may create a home for a favoured group of workers but that is a home not available to less-favoured groups. Indeed, by restricting the amount of non-social homes built, such plans actually achieve the opposite of what is intended: they push up the general level of prices.

The only significant change that Government can make is to planning laws: to make much more land available for development, and also to allow much higher densities.

But even if there were plenty of land, prices would still be out of line. In the US, where there is no overall land shortage, there has been a housing boom comparable to our own. It is only now gradually subsiding.

The only way through will be by a series of small adjustments. These will include more house-building, the easing of planning regulations, higher real interest rates to contain prices and encourage people not to over-house themselves, and schemes to encourage first-time buyers to get on the ladder. But these steps will take time. We have in the past ten years created a serious problem of housing affordability and it will take another decade to get things back on track.