Storm The Page 3
What made the British housing price bubble so dangerous in economic terms was that it was so highly leveraged (that is, supported by debt). The thousands of first-time buyers who acquired what came to be known as ‘suicide mortgages’ of 125 per cent of the property value were merely the vanguard of an army marching to the rhythm of ever increasing house prices. They borrowed to the limits of their capacity, or beyond, in order to get a foothold on the housing ladder. Mainly because of mortgages, but partly also because of personal borrowing, average household debt has risen to 160 per cent of income, double the 1997 level – the highest of any developed country, and the highest in British economic history.
It might reasonably be asked why these developments were allowed to continue unchecked, not least by the guardians of financial stability in the Bank of England and by the political over-lord of the economy, the Chancellor of the Exchequer. There were many expressions of anxiety about increasing personal debt, and it was clear that growing numbers of people were being encouraged – in some cases through aggressive promotion – to take on more debt than they could sensibly manage. In 2002, in the Daily Express, I published a warning about rising household debt and proposed a plan to address it. Then, in November 2003, I raised the issue with Gordon Brown in parliament, in the context of the Budget Report, only to be met with a contemptuous dismissal of the problem:
Dr Vincent Cable ( Twickenham) : Is not the brutal truth that with investment, exports and manufacturing output stagnating or falling, the growth of the British economy is sustained by consumer spending pinned against record levels of personal debt, which is secured, if at all, against house prices that the Bank of England describes as well above equilibrium level?
Mr Brown: The Hon. Gentleman has been writing articles in the newspapers, as reflected in his contribution, that spread alarm, without substance, about the state of the British economy…
A more heavyweight intervention than mine was the warning of the Governor of the Bank of England, who was especially concerned about escalating housing prices. Although prices continued to increase for three more years, he failed, unaccountably, to return to the subject. He was presumably persuaded that house prices (as opposed to inflation in goods and services) were not his primary concern, or that the problem, if it existed, was manageable.
Those who were comfortable with the boom in house prices and debt argued that high levels of debt acquired through mortgages didn’t really matter, because, unlike in the crash of the early 1990s, there were low interest rates and low unemployment. But there are some simple fallacies in that argument which are now being uncovered in the reality of burgeoning orders for house repossessions and growing numbers of households in arrears.
First, bank lending rates were indeed at a relatively low 7.5 per cent even at their peak in July 2007, as against 15 per cent at the end of the boom in the late 1980s. But inflation was much lower too (2.5 per cent versus 10 per cent), so the real cost of borrowing was much the same.
Second, the massive increase in house prices – and the willingness of the banks to lend – meant that the absolute size of mortgage debt, and therefore debt servicing, grew substantially. The average size of a mortgage increased from £40,000 in 1999 to around £160,000 before the market crashed. The cost of servicing the debt therefore became even more onerous than in the earlier periods of financial stress, despite lower interest rates. Debt servicing as a share of household income reached 20 per cent a year ago, higher than in the earlier peak year of 1991.
Third, even before unemployment rose alarmingly at the end of 2008, unemployment was not the only cause of breakdown in families’ ability to service debt – so were illness, pregnancy, short-time working, small variations in incomes, and redundancy due to the constant churning of the labour market. Nor is there much by way of a safety net. After 1995 benefits no longer covered mortgage payments for the first nine months out of work, after which time it is usually too late (though the government has recently relaxed the conditions). Some households have tried to insure against temporary loss of income; but only one fifth have done so, and the policies have been so expensive and so hedged around with exclusions that the competition authorities have been moved to investigate the sharp practices involved.
The leverage of mortgage debt adds two new potent ingredients to the cocktail of problems created by a collapsing housing market. One is negative equity. If prices were to fall by 30 per cent from the peak, an estimated 3–3.5 million households would be at risk of having housing debts greater than the value of their property. That position has been reached in some English towns and cities, although the average price fall, a year after the onset of the crisis, was around 20 per cent (with much larger falls in commercial property). But in London – or at least the more affluent parts of it – there was little sign of the major problems being experienced in the provinces. While negative equity is not a disaster for those people happy to stay put, it necessarily reduces families’ wealth and their willingness to borrow further and spend. The other consequence of unsustainable debt service is mortgage arrears leading to repossession. It has been cheerfully assumed that there could not be a repetition of the early 1990s, when 300,000 people lost their homes in the space of five years. We are, however, unfortunately now heading in that direction, if not beyond it. Annual repossession rates are estimated at 45,000 in 2008, up from 27,000 in 2007, but were expected to rise further in 2009. A variety of mortgage support schemes and forbearance arrangements are currently holding back a surge of repossessions, but if unemployment continues to rise and there is a return to more normal levels of interest rates, the dam will burst.
The growth of second-charge mortgages on personal loans and the securitization of mortgages have meant that there has been a weakening in banking based upon personal relationships with bank managers; a default in payments now often automatically triggers a court reference, the first step on the road to repossession. For most, repossession means the loss of a home, and creates more pressure on the dwindling stock of social housing. There the new homeless are competing with the 80,000 already in temporary accommodation and the 1.7 million homeless (in England alone) on council lists waiting for social housing, usually because of overcrowding or unsatisfactory conditions in the private rented sector.
When housing bubbles have burst before, prices have fallen, restoring affordability and a new balance. This time things are not so straightforward. The bursting of the housing bubble coincides with, and is partially attributable to, the credit crunch: the unwillingness of banks to lend. Because the market in mortgage securities has collapsed, banks are no longer able to raise money, other than through new deposits, so their ability to make new loans has been sharply, brutally cut. As banks have adjusted – not before time – to more realistic levels of risk, they are demanding bigger deposits, of as much as 25 per cent of the value of a home, and often will not lend at all. First-time buyers, at the time of writing, were having to raise 100 per cent of their annual take-home pay in order to cover the up-front costs of buying a house. We have a perverse situation where prices have been falling but affordability has also been declining. Not surprisingly, demand has evaporated, driving the market down even further.
Thus what has happened is not a correction in the housing market, with a welcome fall in prices caused by increases in supply relative to demand. Instead, prices have fallen because of the cost of and non-availability of credit. And supply has also fallen because of a collapse in the building industry. In the latter part of 2009 planning applications were running at a lower level than at any time since 1948 and home constructions at the lowest level since the 1920s. There is now a great danger that, if credit were once again to become easily available, there would then be a (temporary) reinflation of the bubble, creating the potential for another crash. With endless repetition of ‘good news’ about rising house prices, that prospect is becoming all too real.
The problems of a deflating housing bubble did not end with hous
eholders in arrears or in negative equity. The bottom fell out of the market for new housing. New housing developments, for sale or for buy-to-let, have been coming to completion for which there are no buyers or tenants. Many buy-to-let landlords have fallen into arrears. And, behind them, developers have been left with unsaleable stock. There has been a dramatic impact on the house-building industry, with a decline in the number of houses built from 170,000 down to an estimated 100,000 in 2008, with the loss of 100,000 construction jobs, including specialist craft and professional skills which will be difficult to reassemble. House builders have seen their share prices fall dramatically and some have gone under. And because Britain’s planning system links new social housing to new private housing, the supply of social housing has been dragged down too.
Then the emergence of bad debt among home buyers in a falling market has had knock-on effects on the banks that have lent the money. Banks with a large mortgage portfolio, like Northern Rock, Bradford & Bingley and Alliance & Leicester, had to acknowledge the risk of large and growing losses on their mortgage books, added to the losses from other market activities. Banks responded in time-honoured fashion: by cracking down hard on those to whom they had been only too keen to lend in happier times. Then, in September 2008, the generalized collapse of confidence in banks led to the virtual disappearance of the traditional specialist mortgage lenders. The share price of Bradford & Bingley collapsed and the bank was promptly nationalized in order to prevent a Northern Rock-style saga. Halifax–Bank of Scotland (HBOS) was absorbed by Lloyds in order to prevent its collapsing in turn, before both had to be saved and recapitalized by the government, as was the Royal Bank of Scotland / NatWest. By this stage we were no longer dealing with a British housing and banking problem but with a global financial crisis, and I return to that bigger story in the next chapter.
The combined effect of the credit crunch, the deteriorating housing market, and the squeeze on living standards from the earlier hike in energy and food prices created the conditions for a recession. At the end of 2008 recession psychology was taking over rapidly. Consumers had become very anxious. They were reluctant to spend. Retail sales were falling sharply. And this in turn led to a slowdown in production, workers were being laid off, more people were unable to sustain mortgage and other debt payments, and pessimism was deepening in a vicious circle. At some point producers or consumers or both will recover their nerve and start to spend and invest, but that generalized confidence had not returned by the autumn of 2009, although the sense of crisis and panic had passed. One of the central premises of post-war Keynesian economics has been that government policy measures should be used to stimulate demand during a recession. And the shared understanding from previous financial crises, notably that of the 1930s, has been that such intervention has to be decisive and rapid. These insights have informed policy in the UK, and elsewhere, throughout this crisis and have undoubtedly had an impact.
The obvious first step was to cut interest rates. It is common ground among both monetarists and Keynesians that this is the first and quickest way to stimulate demand. One problem has been that the government has transferred the power to set interest rates to the Bank of England, which has an explicit mandate to use interest rates to curb consumer price inflation, which at the height of the crisis was running well above the official target level of 2 per cent. The Bank of England was initially torn between its commitment to combat inflation and a wish to stimulate the economy with interest rate cuts. There was no easy answer to this dilemma. Faced with precisely the same problem, the eurozone authorities initially opted to raise rates and the USA to cut them, because they assessed the balance of risks in different ways. But by October 2008 it had become clear that the British banking system was caught up in a global financial crisis of massive and dangerous proportions. One of the few remedies open to the authorities in order to prevent a slump was a big cut in the interest rate. For those of us who believed in the principle of operational independence for the Bank of England there was a dilemma: to defer to the Bank, which seemed to be moving too slowly, or to call publicly for a deep cut, recognizing exceptional circumstances. I called for a rate cut of 2 per cent. The Bank of England got there in stages, helped by a concerted 0.5 per cent cut agreed between central banks in October 2008, followed by a unilateral cut of 1.5 per cent, to 3 per cent, in November, and a further cut to 2 per cent in December. These cuts undoubtedly had an impact, but in the short run the normal transmission mechanism had largely broken down. The credit crunch was restricting the supply of credit, whatever the price. Monetary authorities in the UK and elsewhere recognized that parallel action was necessary to restore normal bank lending, involving unorthodox measures to boost the supply of money, as discussed in chapter 7.
There has been more controversy over whether it is also necessary to stimulate the economy by running a larger budget deficit. This is already happening automatically, since as the economy slows there will be weaker tax receipts from personal and corporate income, VAT and stamp duty. But there is anxiety that, even without the impact of recession, the government has been running an excessive, structural, deficit. The OECD, among others, was very critical of the British government’s gradual drift into larger, unplanned deficits, even before the problem of the recession arose. In December 2008 there was an increasingly polarized debate about whether Britain’s public finances were strong enough to permit a small fiscal stimulus, of around 1 per cent of GDP, on top of a current (that is, excluding public investment) deficit of 9 per cent of GDP, expected in any event. Critics argue that if the government’s borrowing requirement spirals out of control, then the cost of borrowing in international markets will rise on the fear of sovereign default, perhaps in a dramatic way.
The issue of managing the public sector deficit is emerging as a central issue in economic policy, and in politics. As it happens, the government is experiencing no serious difficulty in marketing government gilts, despite very low interest rates (less than 2 per cent in real terms). And the current, outstanding, UK public debt is moderate in comparison with those of other countries, or with much of the last two centuries. The overwhelming consensus among economic analysts and policy makers is that the government (and other governments) has been right to maintain expansionary policies and to run large fiscal deficits throughout the crisis (which is not yet over), and that conservative critics have been wrong. The point may, however, be approaching at which it is necessary to signal to the markets that, as the threat of a major slump recedes and recession is abating, the government has clear plans to cut its borrowing, which is now, at 13–14 per cent of GDP, at a level that would be seen as absolutely extraordinary in normal times.
Because so much of the uncertainty and worry besetting the UK economy has centred on the housing market, there has also been an argument to the effect that any attempt to rescue the economy from a downward spiral of declining confidence, declining spending, and declining activity should centre on shoring up house prices. The banks, as well as builders and property owners, are, unsurprisingly, proponents of this approach. Various ideas have been canvassed, including direct or indirect state guarantees for new loans, stamp duty suspension or reduction, or the state funding of mortgage arrears through the benefits system. A moderate reduction in stamp duty was attempted in September 2008 and sank without trace. There has also been a modest programme to assist people who are out of work to pay their mortgages. But the government and the Bank of England have essentially declined any suggestions that they should stop the housing market adjusting through a substantial fall in prices. This adjustment is now taking place, although there is the danger of a premature and artificial recovery.
The most dramatic and far-reaching interventions in the UK economy have not been in monetary or fiscal policy, nor in the housing market, but in the banking system. In that respect Britain was caught up in a wider international banking crisis. But this is not to minimize the specific shock to the British economy of having several
banks nationalized, others partly nationalized, and others still dependent for their survival on government guarantees. Britain also pioneered what became a collective response to the crisis in the form of recapitalizing banks through government capital.
The global nature of the crisis has left in its wake a somewhat confusing and unsatisfactory political debate, in which the government claims that the financial crisis and its aftermath of recession are problems whose origins lie exclusively overseas, while its critics, notably the Conservative opposition, simply blame the government for mismanagement. A balanced assessment has to be that there is both an international and a domestic dimension. Without diminishing in any way the global origins and nature of the crisis it is also necessary to debunk the self-serving myth that Britain has, in Gordon Brown’s words, created an economic environment of ‘no more boom and bust’, and that the country was uniquely well placed to ride out the global storm. On the contrary, Britain’s housing and debt bubbles have been larger than elsewhere; the government has relatively limited freedom of manoeuvre in fiscal policy because of structural deficits; and a large financial services sector, centred on the City of London, has exposed the UK to the full force of the gale that is blowing through international financial markets.
These failings are not just technical, but reflect deep social currents. The extremity of Britain’s housing bubble stems ultimately from a national obsession with property and property values. Those who feel that they must ‘have a foot on the property ladder’ are not just making a calculated assessment about the future value of a capital asset, but are buying into the notion that ‘an Englishman’s home is his castle’ and into the concept of a ‘property owning democracy’. Mrs Thatcher’s brilliantly populist ‘right to buy’ policy – under which council tenants could buy their homes, usually at a hefty discount to the market price – contributed mightily to the idea of the ‘first-time buyer’ as an essential pillar of society, an iconic figure on a par with the self-sacrificing, saintly NHS nurse or the self-made entrepreneur. New Labour understood perfectly the importance of the icon: the sense of self-esteem and security that came from discovering that one’s own bricks and mortar were worth more and more; the economic value and personal satisfaction derived from home and garden improvements. The plethora of TV property programmes and the domination of national newspapers by property supplements and house price stories reflected our national mania. It is not in the least surprising that a bubble in property prices was allowed to run out of control. The government now faces the anger of voters whose dreams of a property-based nirvana are now being dashed.