Stephen King: The housing market is one of the main unknowns in any upturn

The flexible labour market may mean tremendous downward pressure on wages

The green shoots. Light at the end of the tunnel. On hearing the first cuckoo in spring. I'm beginning to lose count of the metaphors being employed to describe the signs of recovery in the UK and elsewhere.

There can be no doubt that an improvement is on the way following the economic collapse in the final quarter of 2008 and the first quarter of 2009. Indeed, Karen Ward, HSBC's UK economist, has just revised upwards her forecasts for economic activity this year and next.

She now expects a contraction of 3.3 per cent this year (from her previous forecast of a 3.8 per cent fall) and an increase next year of 1.4 per cent (from a 0.3 per cent fall). While such an outcome would still leave the UK economy in a precarious position, it is not quite the disaster which had previously threatened to unfold.

Nevertheless, there are still plenty of hurdles to overcome. One of these is negative equity, which occurs when the market value of a property falls below the outstanding value of the mortgage secured upon it. Negative equity was the bane of economic life in the early-1990s. The term entered popular discourse as a key reason behind the depth and persistence of the downswing back then.

Given the 20 per cent drop in house prices which has occurred since the autumn of 2007, negative equity is again rearing its ugly head. How much of a problem is it likely to be?

In the latest edition of its Quarterly Bulletin, the Bank of England tries to provide an answer. In an article entitled "The economics and estimation of negative equity", the Bank suggests that 7-11 per cent of UK owner-occupiers were in negative equity in the spring of 2009, a rather similar set of numbers to those in the early- to mid-1990s. Admittedly, as the authors observe, there are myriad uncertainties associated with providing estimates of negative equity but, nevertheless, the situation appears to be pretty bad.

It could, though, have been a lot worse. The fall in house prices seen during this downswing to date has been quicker and more violent than in the early-1990s. Back then, it took almost six years for house prices to fall by around 15 per cent. Interest-only mortgages have grown quickly in recent years, reducing the pace at which some homebuyers have repaid their mortgage principal. And, although there is no technical definition in the UK of so-called sub-prime customers, there was significant growth in lending in recent years to "adverse credit borrowers", those who enjoy, if I can put it politely, a somewhat chequered credit history involving, for example, County Court Judgements and Bankruptcy Orders.

By the end of 2007, this group of people accounted for 3-4 per cent of the mortgage stock.

Not all the news has been bad. Notwithstanding the growth of sub-prime, the proportion of mortgages issued at high loan-to-value ratios in more recent times has been quite a lot lower than it was in the late-1980s and early-1990s (see the left-hand chart). Perhaps much higher rates of stamp duty, combined with the abolition of mortgage interest relief, have reduced the incentive for the housing market to "churn", at least compared with the late-1980s boom.

There are, though, some remaining uncertainties. Unemployment in the UK hasn't risen very far as yet. It might still do so. Then, more and more people would find themselves unable easily to service their mortgages. Any forced selling of houses that came about as a result would presumably increase the numbers facing negative equity. And a further increase in negative equity would, in turn, raise vulnerabilities within the financial system. During the earlier housing boom, banks funded loans increasingly through the sale of securitised assets. That market, though, has collapsed amidst mistrust and recriminations. Further house price declines have the potential to reveal further weaknesses, leaving banks unwilling and unable to return to the lending volumes of several years ago.

Nevertheless, rather than seeing the housing market as a source of further economic collapse, a better bet at the moment is to regard it as a constraint on the pace of any recovery. Interest-rate cuts have certainly helped the housing market's cause, but the benefits are partly being used to pay down debt rather than to crank up new borrowing. Banks are prepared to lend more than they were, but first-time buyers simply can't borrow the amounts on offer earlier in the decade. That means they'll have to save more money before getting a foot on the housing ladder.

And, in this economic cycle, there are puzzles of a kind we haven't really had to deal with before. The much-vaunted flexibility of the British labour market may reduce the risk of a sharp rise in unemployment but only at the expense of tremendous downward pressure on wages and salaries. This kind of deflationary environment might be helpful for profits (to the extent that individual companies can cut costs more easily than before) but it doesn't really help those households who are now burdened with high debts. Fortunately, interest rates are a lot lower than they were, which has massively reduced the debt-service costs associated with these high debt levels. But low interest rates, on their own, may not be enough to kick-start economic activity if wages begin to shrink. After all, Japan has "benefited" from low interest rates for years, but the Japanese economy has succeeded only in disappointing, year in, year out.

Japan's experience raises big questions not about the depth of recession but, instead, about the pace of future economic growth. Japan's debt problems were in the corporate rather than the household sector. Falling land prices were, therefore, more a problem for commercial rather than residential property. Nevertheless, Japan ultimately threw all the macroeconomic policy tools available to bring to an end its stagnation, without any real success.

For the UK, there are some obvious worries. First, the absence of easy credit is likely to limit the scale of any recovery. After months of heavy de-stocking, it now seems likely that firms are gearing up to produce a bit more – which should be consistent with higher output in the near term. Many small and medium-sized companies, though, will still struggle to survive, even allowing for a bit more activity. Their bank managers are not as friendly as they used to be.

Second, although the decline in sterling is undoubtedly a good thing for exporters, the degree to which exports can recover depends also on the extent of any rebound in demand in the UK's main trading partners. As many of these are in Europe, and the European economy is out for the count, the benefits of a weaker exchange rate may not be quite as big as policymakers hope.

Third, as taxpayers wake up to the terrible state of the public finances, the incentive to save rather than spend is rising quickly. In Japan, for every increase in government borrowing there was an even bigger increase in corporate saving, thereby destroying any Keynesian multiplier effect. Admittedly, British consumers are not known for their caution but, nevertheless, faced with a budget deficit of over 12 per cent of national income, it may be time to think about saving the pennies in anticipation of higher taxes and a reduction in "essential" public services.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com