It Is Time To Manage Asset Bubbles

Written by Vincent Cable MP on Wed 22nd Jan 2003

The new Labour government earned plaudits in 1997 by making the Bank of England independent, with a mandate to control inflation by setting interest rates.

It cannot continue to rest on its laurels but now has to address a greater threat to economic stability: the generation and bursting of asset bubbles. This means the government challenging some of the established orthodoxies and vested interests in financial deregulation.

One - partially - burst bubble, the collapse of equity prices, with a fall of 45% in the FTSE since the peak, has already created serious problems for the occupational and private pensions industry, which could get worse.

Further inflation and subsequent collapse in the housing market will have even more dire consequences.

Even the governor-designate of the Bank of England acknowledges that recent house price inflation of 25 to 30% is unsustainable and also dangerous.

The average house price to earnings ratio is now over 5.5, an all time high. Yet the current expansion of the housing market through equity withdrawal is driving private consumption growth and, thence, the expansion of the economy.

Mortgage equity withdrawal was over 6% of consumer spending last year. A reversal and a move to negative equity could well lead to a negative demand shock through a slump in consumer spending.

Optimists would argue that such an adjustment is necessary and desirable. A drop in house prices - or even a stabilisation - followed by a reining in of consumer spending could help to correct the current imbalances in the economy, making it easier for the Bank of England to cut interest rates, which could in turn reverse the serious over valuation of the exchange rate and ease pressure on businesses in the traded sector of the economy.

A few reckless lenders and borrowers might get hurt but that is in the nature of a market correction and perhaps well deserved.

Moreover, optimists would argue, a fall in house prices would have the socially desirable consequence of reversing the growing apartheid in the housing market which, in constituencies like mine, is preventing not just low paid workers but middle income managers, doctors or head teachers purchasing homes in the area.

It is implicit in the government's passivity that it expects such a correction to occur and to be benign in its effects.

There are however several good reasons for believing that all may not be for the best.

The first is that the inevitable market correction may not be smooth, but savage, as market corrections often are. There is little consensus on future house price movements.

Those in the mortgage lending business, who have a strong vested interest in benign outcomes, unsurprisingly predict a 'soft landing'. There are reassuring voices in the New Year that the market is 'cooling off'. Others suggest that the current mania could be further fuelled by panic and greed.

Some first-time buyers are being persuaded to take big risks in order to get onto the housing ladder. Some disillusioned punters who have abandoned stocks and shares have been persuaded to speculate in what appear to be more certain gains from bricks and mortar.

Roger Bootle's Capital Economics predicts that prices could rise by 20% in 2003 before crashing. It does seem inherently implausible that prices will stabilise for the next 20 years until earnings catch up with prices; they are much more likely to crash.

There is academic support for this assertion in research by the Bank of International Settlements which suggests that the majority of property booms do lead to busts (examples being in the UK in 1973 and 1989) unlike the majority of equity price booms.

A second reason for alarm is that, if there is a sharp correction leading to a negative 'demand shock', the conventional tools of macroeconomic management may not work.

With nominal interest rates at 4% and inflation also very low it is not possible to use interest rates aggressively as it was in the 1990's when interest rates fell from 15% (8% real) to 4% (2 real). And, despite the relative comfort of Britain's fiscal deficit and public debt position, markets are already nervous about the recent lurch into deficit financing.

Expansive fiscal policy would then manifest itself in rising long-term interest rates rather than effective demand stimulus. Too little attention has been paid in the West to the experience of Japan where conventional macroeconomic management has proved largely powerless to lift an economy brought low by a collapsing asset bubble and suffering deflation.

A third worry, whose importance has also been highlighted by Japan, is that collapsing asset values can bring into question the stability of lending institutions which have lent substantially against assets at inflated values.

Standard and Poor's warning that British banks are operating at risk levels comparable to those of Portugal and Panama has been greeted with predictable outrage by the British financial establishment, but markets are more likely to heed the leading, independent, credit rating agency.

A harbinger of what may be in store for the banks is the position of the life assurance sector which, in the wake of steeply falling equity prices, has seen growing difficulty for the leading life insurers (and, of course, their policy holders) including near insolvency for Equitable Life.

Last, but not least, is the potential impact on over stretched borrowers. The optimistic assumption being made at present that because interest rates are so low borrowers can cope.

Interest payments are currently around 7% of household income, way below the peak of over 14% in 1991 (for first-time buyers the ratio has fallen from 20% to 14%). However if incomes fall and unemployment rises, significant numbers will be unable to sustain mortgage payments.

There is no longer a cushion of support through the social security system for those in arrears. Forced selling could drive prices down and aggravate negative equity. Repossession could become a substantial problem as it was in the early 1990's.

There are good reasons, therefore, for intervention to stabilise the housing market to prevent further rapid inflation and to cushion any subsequent fall. What policy options are available?

Interest rates cannot satisfactorily be used in the present environment. The housing market currently requires an interest rate increase; the depressed traded sector of the economy a decrease.

Alan Greenspan has helpfully enunciated a broader principle that interest rates should not be used for countering asset bubbles. And should Britain join EMU this option will not be available in any event.

Tax instruments are not an effective alternative either. The loss of mortgage tax relief has made little difference; when nominal interest rates are low the loss of tax relief costs the mortgage payer less. Stamp duty can be varied by region to reflect different market pressures but is a tax on transactions rather than ownership, and depresses housing supply as much as demand.

There is an obvious requirement too for an additional supply of affordable homes to let and buy in overheated markets like the south east; but the land and planning problems are complex and will not be resolved quickly enough to influence the market in the short term.

Action will have to be taken, instead, on the availability and terms of mortgage credit. This idea has been criticised, even ridiculed, in the past as bringing back the pre-Thatcher era of credit controls. In practice, policy options are available which are compatible with the world of competitive, globalised markets.

First, the British authorities are required, in any event, to monitor the capital adequacy - the cash reserves - of the banking system under international (Basel) agreements.

These obligations could be turned into an active instrument of policy by quarantining cash held by mortgage lenders in periods of market overheating and relaxing requirements in periods of serious market turndown.

Samuel Brittain has endorsed this approach: requiring mortgage lenders to place variable special deposits with the Bank of England. A similar approach to intervention is already taken in respect of equity markets where the regulator (the FSA) has applied flexibility to the "resilience test" (of reserves) in the insurance sector in order to prevent unnecessary technical selling.

Second, the Financial Service Authority already has a role regulating individual mortgage lenders.

Its remit should include systematically reining back the more reckless institutions (Northern Rock is an example) which are operating on dangerously high loan to asset ratios. Revised Basel requirements will in fact, set levels of prudent credit for industrial lenders, and these requirements could be anticipated.

There would need to be an analytical basis for making decisions on when to intervene; the Monetary Policy Committee or a separate asset valuation committee in the Bank of England (as recommended by John Calverly of Amex) would study trends in asset prices and seek to judge reasonable ranges beyond which warnings, and then intervention, would be called for.

I do not pretend that this is necessarily a technically easy task. There are different theories of what drives house prices. But this is true also of inflation more generally. The fact that the Bank has been extremely bashful in pronouncing on the housing market is not helpful; its future credibility rests on taking a clear view and, if necessary, the Chancellor should tell the MPC that that is part of what it is paid for.

While an active approach to managing asset bubbles presents formidable technical challenges to the Bank of England and the FSA, the real challenge is to the government. It is still mesmerised by the Thatcherite orthodoxies of the last two decades. If it wants to salvage its reputation for economic competence it will now have to venture beyond them.