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Forever blowing bubbles

Those attracted by the ‘buy-to-let’ bonanza, turning themselves into mini-rentiers in a bid to escape wage slavery forever, are likely to get their fingers burnt

Rarely a week goes by without the TV news reporting that house prices in the UK are at ‘an all time high’. And rarely does a week go by without newspapers like the Daily Mail running stories about how rising interest rates are going to negatively affect house prices and end up bankrupting half the country. In the popular press, if house prices are rising it is a case of ‘feel the wealth’; if there is a sense they might decline it is ‘fear for the future’ instead. You could be forgiven for thinking that the health of the entire economy rested on rising house prices.

In a sane society, of course, houses and other buildings would be wanted simply as desirable places to live in rather than as supposed generators of wealth, and it is tempting to suggest that an economy based on house prices can only come about because the generation of real wealth through industry must no longer be an attractive or viable proposition. Though superficially appealing, this would be wrong. The sphere of production is where real wealth is created, not in the realm of buying and selling houses or anything else. The inherently cyclical nature of the market economy and the various sectors within it (not all of which move in the same direction at once) means that throughout the history of capitalism ‘bubbles’ have developed in everything from tulip bulbs to micro-chips, based on periodic excess demand, speculation, and the psychological momentum which develops when people perceive that particular assets or commodities are increasing in value.

Since the 1970s and 80s, the way people view housing in the UK (and many other countries too) has changed. In capitalism’s ‘property-owning democracy’ houses are seen as a store of wealth and those buying them are encouraged by an entire industry of property firms, banks, building societies and estate agents to pin their faith on ever-higher house prices. That this is peculiar never occurs to most, but it is one of the strangest facets of the modern economy. What other commodity, when subject to massive price rises, garners such a positive response – rising car prices, food, or furniture? Only houses – and precisely because, in a society where over half of all households have less than £1,500 in savings, they are now seen as the main store of wealth and, ultimately, as an investment.

Rising prices are nearly always seen as being bad, except when it comes to house prices – indeed, with annual house price increases often running between 10 and 20 per cent in recent years, this has been viewed as especially good. What makes it odd is that a house is the single biggest thing most people ever purchase, and in a great many cases it eats up a higher proportion of income than all other expenditure put together, which is one reason why falling house prices are not the one-sided disaster usually supposed (at least not for buyers).

Importantly, houses are evidently not a source of wealth for most people with huge mortgages to pay – they are a source of debt. Average household debt in the UK is currently around £45,000 and four-fifths of this is accounted for by mortgage debt. There is widespread confusion about the extent of debt involved in buying a house too, as the powers of compound interest are not always apparent – few with a typical 25-year £120,000 mortgage will realise that even at current (comparatively low) interest rates they will be paying back a total of around £270,000 in today’s money.

Myths about house prices

There are problems with houses as a store of value in that they are an illiquid asset (you cannot convert them into cash easily) and, other things being equal, merely buying and selling them is what economists would call a ‘zero sum game’ – and not even this if costs and taxes are taken into account. This is, of course, unless you can (profitably) add value to them in other ways, are wealthy enough to own more than the one you live in and can sell at a real profit to the original price paid, or you sell up and move somewhere prices are cheaper on a like-for-like basis.

Spurred on by the popular press and relentless so-called ‘property porn’ programmes on television, myths about houses and UK house prices abound, the following probably being the most prevalent, and illustrative of the present speculative bubble:

House prices never go down

Buy-to-let is a sure-fire winner

Renting is ‘dead money’.

The idea that house prices never go down is as bizarre as the notion that stock markets never fall. And it is just as incorrect, redolent of the kind of short-sighted mania that occurs during any bubble, from the ‘tulip-mania’ affecting Dutch tulip bulbs of the 17th century to the recent ‘dot com’ crash. The United States – which has had far higher levels of home ownership than Britain over the last 150 years or so – has seen several house price crashes, including after the bubbles of the 1830s, 1880s, 1920s and 1970s. A Florida mansion, for instance, bought in 1925 during the bubble of the ‘roaring twenties’ would not have reached its initial buying price again until forty years later.

Since the increase in home ownership in the UK over recent decades, a similar pattern has emerged. Just as with the stock market, the overall price trend may be upwards, but with some very noticeable periods of decline. The picture is sometimes partially obscured by the effects of general inflation, but once this is stripped away, it is clear.

For instance, the property boom of the early 1970s led to an 18.1 percent fall in house prices in real terms (i.e. taking inflation in account) between 1975-77. When the recession of the early 1980s hit, real house prices fell again. As unemployment took off to the highest levels since the Second World War, between 1979-82 house prices fell 17 percent (accounting for inflation). Then, as house ownership spread among the working class under the Thatcher government and levels of indebtedness soared to pay for it, the biggest crash was the most recent one in the 1990s, plunging millions of people into ‘negative equity’, where their houses were worth less than their outstanding mortgages, ending with hundreds of thousands of homes being re-possessed by the banks.

On this occasion, house prices fell 37.3 percent in real terms from their peak during the ‘Lawson boom’ in 1989 and didn’t recover fully on this measure until the beginning of 2002 (using the nominal ‘headline’ figures, the average UK house price in 1989 peaked at ú62,782 and eventually rose above this level again in early 1998, but this doesn’t take inflation into account as ú62,782 was worth considerably less in 1998 than it was in 1989). The bottom of this crash was in late 1993, and after that the housing market first started to recover, and then soared, to the extent that the average UK house is now around ú180,000, an increase in real terms of over 150 percent since the 1993 low (all figures supplied by, or calculated from, the Nationwide Building Society quarterly surveys). This is over three times the rate at which the UK economy as a whole grew during the same period.

As a housing bubble, it is unparalleled in the history of the UK economy. Apart from the usual cyclical upswing and the relative boom in the UK economy over the last decade, it has been fuelled by two other factors. The first is the particular, continued expansion of the financial services sector centred in London and the South-East, which has had a ‘ripple effect’ on house prices across the country. The second has been the ‘buy-to-let’ bonanza, whereby people, realising that owning just the one house isn’t the best way of taking advantage of a rising market, borrow speculatively to buy two or more instead, hoping that the rental yield from the houses purchased will cover their massively increased mortgage payments. This development has, in turn, partly been sustained by the influx of migrant labour from Eastern Europe which has provided a rental market when most people in the UK have been encouraged to buy.

While historically it has often been the case that it is cheaper to take out a mortgage than rent (one of the few advantages of mortgages is that they are a cheaper form of debt than most), nevertheless this has not always been so. The over-supply of rental accommodation in many areas is such that is now cheaper to rent than to buy, and the rental yield received by the ‘buy-to-let’ brigade (the market rent for property divided by its price) is currently falling to around 4 percent.

Unsustainable debt

How has this house price bubble been financed? Purely and simply through debt, and increasing amounts of it. The two best measurements of the growing indebtedness underpinning UK housing market rises are average incomes as a proportion of average house prices, and the average multiple of income allowed by banks and building societies when they agree mortgage levels with house buyers.

The average house price to average earnings ratio tends to increase notably during housing bubbles as prices rise at rates that far outstrip any growth in incomes. The long-term UK average has been for house prices to be around 3.5 times average earnings, though in the early-mid 1970s bubble this rose to over 4.5 times earnings, and in the late 1980s bubble to just under five times earnings. Today, it stands at nearly seven times average earnings.

The salary multiples which banks and building societies use to determine how much they will lend house purchasers when they grant mortgages has also increased massively. This had to happen because house prices have risen far more than wage increases. In the 1970s it was rare for financial institutions to issue mortgages that were greater than three times household income, then it went up to four times income in the 1980s until Abbey confirmed what many knew to be a reality last year when they admitted that they (and others) now lend at multiples of five times income, placing a massive financial burden on those with mortgages. What this huge indebtedness means is that the risk of default on mortgages, including mortgages for ‘buy-to-let’, is now significant; but this is a risk financial institutions have taken in the hope that rising house prices can be maintained forever.

Housing as an investment

Those who have been persuaded by the financial institutions and the media to get onto the ‘housing ladder’ largely on the grounds that it will be a good investment, might not have realised that in the popular game there are snakes as well as ladders whereby you can go down as well as up. This is largely due to the cyclical rhythm of the market economy (where it is better to buy when prices are low and sell when they are high, rather than follow the herd and buy near the peak when things have never looked better, just before it all turns to dust). Furthermore, there is a phenomenon at work behind all this that is rather revealing.

Within capitalism there’s a variety of competing asset classes for those who are looking to expand their wealth (primarily capitalists and large institutions, but also anyone else with some spare cash to invest). These mainly include equities (company shares), bonds (such as government gilt-edged securities), cash in savings accounts, and property (commercial and residential). Led by financial institutions like Barclays Capital and Credit Suisse First Boston, there is quite an industry comparing the performance of these leading asset classes. Some are far more volatile than others, with equities being the most volatile, cash the least so. But property has been the next most volatile asset after equities with considerable short-to-medium term risk attached to it. While historically performing better than cash or bonds, property has performed noticeably less well than equities too (even though shares are rightly viewed as risky short-to-medium term assets by most – apart from when there’s a bubble, of course).

The US sub-prime market

Such has been the rush to buy houses at almost literally any price that the fortunes of the housing market have spilled over to affect other assets. Most notably, in February and March world stock markets were adversely affected by growing problems in United States’ sub-prime mortgages, caused by what are now falling house prices there.

Sub-prime mortgages are those offered in the US to customers with poor credit ratings or already high debt levels. Because they are riskier, interest rates tend to be higher than those on safer (prime) loans. But as the US housing market falters, more sub-prime loans are going bad and at an even faster rate than expected, with over an eighth of them already in arrears (Money Week, 2 March).

The bursting of America’s housing bubble could have widespread impacts on US financial institutions and others who have exposure there (in the UK, this ranges from HSBC bank to construction firms like Taylor Woodrow). And it is perfectly possible that the UK housing bubble may follow suit, with similarly high prices and unsustainable levels of debt no longer being able to defy gravity. Indeed, the entire housing bubble phenomenon is wider than commonly supposed – while the US and UK economies have a particular problem with their housing markets, so do many other countries where identifiable bubbles also exist, from Ireland and Spain to New Zealand.

Where next?

Past history demonstrates that sooner or later, the current housing bubble will end in tears. When asset prices become completely disengaged from what is happening in the real economy where wealth is produced and value created, and are only sustained by ever increasing amounts of indebtedness, it cannot last – capitalism just doesn’t work that way. Its growth is not planned or smooth and some sectors expanding rapidly beyond that which the market can bear is a natural feature of the system. When the crash comes, it will return markets to more realistic levels that are more in line with real incomes and values, and this is what has happened on every other previous occasion.

Just as the major world stock markets (including the UK) lost a colossal 50 per cent of their value in the ‘dot com’ crash of 2000-2003, before beginning their more recent recovery, so – sooner or later – the housing market will follow suit. And two factors in particular could be the trigger for it when it happens.

The first of these is interest rates, which have already been moving higher, and this movement could be propelled further by the backwash from the US sub-prime mortgage problems. Increases in interest rates have been associated with housing market crashes on the majority of occasions they have happened, and for obvious reasons.

The second issue is unemployment. There is a noticeable but unsurprising correlation between movements of house prices in the UK and rising and falling unemployment. Rising unemployment in the mid 1970s helped burst that particular housing bubble, and it also played a major role in the housing market corrections of the early 80s and then of the early to mid 90s, both of which coincided with more general economic slumps. When unemployment began to rise again last year, house prices tailed off, much to popular concern, but since then unemployment has eased slightly and house prices have resumed their upward trend.

What will trigger the crash this time is impossible to tell in advance, even if rising interest rates and unemployment are the most likely causes. Interestingly for those who now see houses primarily as investments rather than places to live, competing returns on asset classes might also give us a clue.

One of the tell-tale signs of a pending stock market crash is when the earnings yield on shares – effectively the profits from capitalist enterprises in relation to share prices – falls below the yield on long-term government bonds, which gives a signal to investors and capitalists generally that the risk associated with owning shares is no longer worthwhile and that investments like gilts are more attractive, being safer and suddenly with a better comparative return. The two most significant stock market collapses since the 1929 Wall Street crash have been 1974, when the UK market, for example, lost three-quarters of its value, and the aforementioned 2000-3 tumble, when the market halved in value. On both occasions, the earnings yield on shares had fallen by some margin below the yield on long-term government bonds (on both occasions the gap was more than 1 percent).

The analogy for the housing market at present is this: if housing is now very much an asset class for investment purposes, it compares unfavourably. According to the Financial Times, the earnings yield on UK equities is currently around 7 percent and for 10 year government bonds just under 5 percent. The rental yield on residential property is now 4 percent and falling, which means that ‘buy-to-let’ is looking like a lot of debt and a lot of risk for a very poor reward (nowhere near enough to cover mortgage payments).

The lessons from this situation seem clear:

that in capitalism what goes rapidly up must come down at speed too, in housing as in much else;

the vast majority of people in society who do not own enough wealth to buy houses outright and who must effectively pay by instalments are likely to be squeezed ever harder by an uncontrollable financial system;

those attracted by the ‘buy-to-let’ bonanza, turning themselves into mini-rentiers in a bid to escape wage slavery forever, are likely to get their fingers burnt.

Sooner or later the bubble will burst, and it will be wage and salary earners without ‘independent means’ – drowning in debt – who are likely to be hardest hit, as the market economy solves a problem it created in the only way it knows.

DAP