The price of a stable housing market

In Britain, taxes on property lapse if it is empty. The incentives are the wrong way round

THERE IS beginning - just beginning - to be a nasty sense of deja vu about the British housing market. Prices are increasing sharply, particularly in the London and the South-east. The papers are full of reports of "hot spots" and articles about where prices are expected to increase most. The middle classes have resumed their favourite dinner-table conversation as if the collapse of the early Nineties never happened: have you made more on your house price so far this year than you have at work? Funny money is back again.

This would all be harmless enough if there were no potential macroeconomic effects. But there might be. The excesses in the housing market were a central part of the story of the late-Eighties Lawson boom which then led ineluctably to the early Nineties Major-Lamont bust. The swings in the housing market - and the consequent swings in the feelgood factor - were the main motor of the business cycle.

The story was in essence simple: financial market liberalisation allowed all sorts of people to borrow money against property. When I first got a mortgage in 1980, I was charged two points above the normal mortgage rate because I was in such a disreputable profession - journalism - and there were strict limits on the amount I could borrow. Within five years, I had refinanced my mortgage, taking out more money to buy a car, and had lower interest payments to boot.

That new ease of borrowing as competition spread among mortgage lenders increased the demand for housing just when real incomes were looking up. It made sense to move into bigger and better homes, bringing forward some of the benefits of higher future incomes.

But the supply of homes was much more sticky. This is partly just because of the natural timelags involved in building, and partly because of planning restrictions and other factors which I will come to.

The rest is history. House prices zoomed and wealth rocketed. Consumers spent as if there were no tomorrow. Inflation began to ratchet up, nearly trebling from 3.4 per cent in 1986 to 9.5 per cent in 1990. The subsequent rise in interest rates hit hard because of the amount of mortgage debt. And, of course, the house-price bubble burst. The graph showing the development of house prices relative to earnings gives the overall picture.

We are a long way from that threat. House prices are relatively low compared with earnings. And housing wealth has hardly edged up at all in this cycle relative to post-tax household income. Overall wealth is where it was at the peak of the Eighties boom, but the composition is very different: much more is in shares, and less in homes. Since two- thirds of shares are in institutions, such as pension funds, the impact on the feelgood factor is small. Share prices also benefit the rich most, and their spending patterns are less affected by wealth changes.

Nevertheless, the beginnings of a serious housing upturn are clearly there. The Bank of England's Inflation Report on Thursday said it had revised its previous expectation that house prices would rise just in line with earnings: in the next two years, it expects house prices to rise at double the rate of earnings - say, 8 against 4 per cent. There are even some signs of one-off increases in demand, rather like the impact of financial market liberalisation in the Eighties. The equivalent today is the current trend towards buying for rental, which is fuelling prices in London and the South-east. Secured lending - mortgages, which account for some 80 per cent of all personal lending - increased by 6.8 per cent over the year to the second quarter.

None of this in itself need be problematic given relatively low prices compared with earnings and the general shortage of housing to let. But the problem is that asset markets like housing tend to be more volatile than ordinary markets. In most markets, a rise in price cuts demand and increases supply. But in asset markets, a rise in price may simply persuade people that prices will rise even further. And that will increase demand and cut supply, creating a self-fulfilling boom. Moreover, the housing market is one of the very few asset markets where you can easily borrow against the security of your home, and thereby small percentage increases in overall prices become temptingly large percentage increases on your own capital.

Banks take a much dimmer view of lending against, say, the security of shares. The proper liberal response is to cut all undue subsidies, and let the market work. But we have virtually achieved that with the imminent abolition of mortgage tax relief. And it is not easy to turn a blind eye to an asset market which, because of past subsidies and public policy, is so crucial to personal wealth and consumer confidence. It may be possible to curb demand to some extent by insisting that lenders put more capital aside against possible bad debts, but regulators traditionally balk at using prudential policy for macroeconomic purposes. If we are not to end up again with the tail wagging the dog - with interest rates rising to deal with an exuberant housing market - we need to look at ways of making housing supply more responsive.

The situation is urgent given the trend to new households as younger people want to live on their own sooner, the married divorce, and old people live longer. Yet there is a paradox: the Government and builders are trying to dump more and more housing on to reluctant rural and semi- rural areas. At the same time, there continue to be blighted areas in cities where supply does not respond either because sites are owned by the public sector, or because private landlords lack adequate incentives to develop or sell to someone who will. This blight takes the form of sites used far below the potential that would be approved by the planning authorities - temporary buildings, second-hand car lots - and ultimately derelict buildings and wasteland. The result is creeping degradation - and then extreme solutions like the Docklands Development Corporation with its predisposition to big buildings and big scale.

How preferable it would be to have a steady flow of private redevelopment on a scale suited to the existing area and encouraging a varied pattern of building. This is precisely what the imposition of some running cost on landowners ensures in cities where owners pay rent or buy leases (Hong Kong, where the state is the land freeholder) or where local taxation is levied on the land value of the site, whether or not it is developed (many US, Australian and Danish municipalities). By contrast, in Britain, taxes levied on property - the council tax, for example - lapse if the property is empty. Britain's incentives are the wrong way round.

The combination of three things - an enormous owner-occupied sector by international standards with all that implies for wealth and the feelgood factor, an ever more ingenious financial sector with the potential to boost housing demand, and serious supply constraints - will always be a macroeconomic accident waiting to happen. If the Treasury does not tackle the supply issues, the Bank of England may have to tackle demand. Gordon Brown, watch out.

Christopher Huhne is a Liberal Democrat member of the European Parliament's Economic and Monetary Affairs Committee, and a vice-chairman of Fitch IBCA, the international rating agency.