The thorny issue of house prices is once again back on the political agenda, or at least it is outside of Downing Street and the Westminster bubble.
Yesterday Rob Williams raised the problem once more on the Compass website. Now while I agree with much of his comment, there are a couple of criticisms I would make.
Firstly, while it is true that house prices are going up again, I don't believe this is predominantly a result of City bonuses, Russian oligarchs or the Cameron bounce. While these factors may have a strong effect in London, elsewhere there are other factors at play. Those are the reduction in the size of deposits that the banks are demanding for each mortgage issued, and the low interest rates that they are currently charging. As I pointed out in this blog last week, this fall in deposits has coincided with rising prices. I do not consider that a coincidence.
This issue of mortgage deposits now brings me to my second criticism. Rob has articulated the problem of house price inflation nicely, but like many before him, has failed to provide a definitive solution to it. Yet find a solution we must. It is no use saying something must be done unless you know what should be done. Unfortunately there are too many economists and political commentators who claim that either nothing can be done, or that the market should be left alone and allowed to correct itself, without intervention, whatever the economic cost. Needless to say it is partly this neo-liberal belief in intelligent markets that got us into this current mess in the first place.
Personally, I would argue that the only positive thing that can be said about the concept of intelligent markets is that they are probably more intelligent than some of the people that believe in them. Quite frankly, to claim that markets are intelligent is about as rational as claiming that gravity is intelligent, or that a bowl of water is intelligent because its surface is always flat and so that means that the water must always be capable of finding its own level.
The truth is that the surface of a bowl of water is flat because of the laws of thermodynamics. Markets find their own level because of the economic laws of supply and demand and competitive advantage. There is no intelligence involved in either, except by those that seek to understand and scientifically quantify the behaviour of each system, or by those that seek to intervene in the behaviour of each. And if we can intervene in the behaviour of natural water systems for our own social and economic benefit (such as by damming rivers and building reservoirs), then by the same token we should also be allowed to intervene in economic systems to improve their social impact.
So, the question remains: how should we intervene in the housing market?
As I again pointed out last week, house price inflation can only be brought under control if the sources of imbalance in supply and demand are tackled. So while many are arguing for increased house-building to increase housing supply, I would argue that that cannot solve the problem in the short term. Nor can it ever respond quickly enough to sufficiently dampen the oscillatory boom and bust cycle. What is needed is a lever that can be pulled that would have a smooth, rapid and proportionate impact on the housing market by reducing demand. Traditionally that lever has been interest rates, but this usually has an adverse affect on business investment, employment and the wider economy. A far better approach would be to regulate bank lending more strictly, and there are essentially three ways that this could be done.
The first would be for the Bank of England (BoE) to set an annual quota for total mortgage lending that would go up or down depending on whether house prices went down or up. This quota would then be divided amongst the various lenders. There are, however, a couple of problems with this approach. The first is that it requires the BoE to interfere in the lending policies of individual banks. This would not be popular, it could be very bureaucratic, and it might be difficult for the BoE to always be seen to be even-handedly in its treatment of different banks. The second problem is that some of those banks might also be less than even-handed in deciding which of their customers they choose to grant mortgages to, and which are sent to the back of the queue (where they will probably remain indefinitely). You don’t need to be a rocket scientist to work out which customers will be first in the queue and which will be last.
A better solution would be to set a fixed limit on the loan-to-earnings ratio for each mortgage applicant. Unfortunately this is one of the two mechanisms Lord Myners specifically ruled out a couple of weeks ago. Why? Who knows?
The third option, and the second proposal Lord Myners discounted, is setting fixed limits on the loan-to-value ratio for every mortgage. In my opinion this is probably the policy that would yield the greatest number of economic benefits.
The easiest way to implement such a policy is by introducing the concept of a Minimum Mortgage Deposit (MMD). This would be the fraction of the value of the house that the buyer must provide in cash that cannot be covered by the mortgage itself. This threshold should be set by the Bank of England’s Monetary Policy Committee (MPC) at the same time as they set base rates. The base rates will continue to control the CPI rate of inflation; the MMD will control house price inflation. A target for house price inflation should be set for the BoE by the Government, just as the target for CPI currently is, but the BoE will then be responsible for meeting this target using MMD. This is the first virtue of this policy. Its mode of operation is almost identical to the already proven mechanism by which CPI inflation is controlled.
For its part, the Bank of England should report annually to Parliament on the state of the housing market, and recommend what it regards as the optimum value for MMD under the current economic climate, and how many new houses need to be built (and where) in order to achieve this in the medium term.
The beauty of this system is that it includes a separation of powers between two potentially antagonistic institutions, the Bank of England and the Government. Each can impose demands on the other, but neither will be able to have control over the parameters under which they themselves are being asked to operate. The BoE has no control over what the house price inflation target will be, and the Government will be told how many houses to build in order to keep the the MMD threshold at an appropriate and acceptable level. Therefore neither can corrupt the system nor damage long term economic stability for their own short-term self-interest. The benefits will also extend beyond the confines of the property market.
This policy, unlike the loan-to-income approach, will force potential house buyers to save before they can buy. In the past that has been futile because house price inflation always meant that the deposit required would rise faster than most people’s capacity to save for it. The 125% mortgage was then introduced to overcome this, but actually made things worse. If house prices are stabilised first, the panic-induced dash to buy will no longer be there. The increased savings will decrease consumer debt, increase the country’s national saving ratio and help recapitalise the banks. With mortgage lending then effectively capped, banks will have more cash to lend to business. Therefore business loans will be more plentiful and cheaper. With housing no longer being the vehicle of choice for investors and speculators, money will flow more freely to other areas, such as the FTSE100 which has stagnated whilst house prices have boomed. That cannot be pure coincidence can it? After all, why would you invest in the stock market with a typical yield of 4%-10% when you can invest in a (seemingly) less risky asset (i.e. housing) that is generating yields that are two or three times as much?
The other advantages of the MMD policy are that it is easy to implement. Most of the necessary powers, people and institutions are already in place. The BoE MPC is already set up and could easily expand its role to cover MMD. Indices for average house prices are already measured by the Land Registry (and also by several banks and building societies). The FSA already has powers to regulate financial services and consumer products, and could therefore monitor the compliance of the banks. Moreover, the FSA has already suggested possibly abolishing 125% and 100% mortgages, so the precedent for this new policy has already been set, except of course that the FSA has now backed down over this approach. Perhaps that is because setting the precise limits on bank lending is not, or should not be, within the remit of the FSA. The FSA is in effect a financial police force. Its role should be to police the activities of financial institutions, not to set monetary and fiscal policies. Those roles should remain with The Treasury and the BoE.
So this policy also has the added bonus of reinforcing the separation of powers between the BoE and the FSA. While this separation of power and responsibility has been the source of much criticism during this financial crisis, it is not a criticism I share. Having two competing institutions does not necessarily mean that there will be cracks in the regulatory framework where no-one takes responsibility. If those two institutions are programmed to compete aggressively with each other for greater regulatory power then that will not happen. Such an outcome, though, depends on the exercising of strong leadership underpinned by positive political support, so any failure of regulation is ultimately the result of either a failure of leadership in the FSA and BoE, or a lack of political will from the Government.
Inevitably some people will look at these proposals and declare that the requirement for mortgage deposits will be impossible to sell to the electorate, because people have become accustomed to getting mortgages on demand. This may be true, but there are a couple of ways to overcome this problem.
The first is to allow banks to lend low value mortgages without large deposits, but only for much smaller loans-to-earnings ratios (say less than 1:3) with the BoE MPC also setting the value of this floating limit on the same monthly basis as they would for MMD and interest rates. Such mortgages would also be suitable for those who wish to re-mortgage when moving home. In effect they would be using existing equity in a property as a form of deposit. If buyers require larger mortgages with higher loans-to-earnings ratios (1:4 or 1:5) then deposits should be required on those mortgages. This has the added bonus in that it introduces an element of choice and diversity into the mortgage market.
The second solution is to introduce the policy gradually. If this is done then most people won't notice the change. For example we could introduce the policy now with the MMD rate set at 5% and it would make no difference to lending practices because currently virtually all mortgages require much larger deposits. If MMD were to subsequently vary by about 1% per year, then once again most people wouldn't really notice.
Ultimately all that is required is for this policy to become reality is for the Government to give the green light, to set the target rate for house price inflation (I would suggest keeping it between the CPI inflation rate and the average growth in earnings), and give the FSA some bigger sticks to beat bad banks with (e.g. fines, increased capital adequacy ratios). Other than that it is a question of timing, and I suspect we may need to wait for the economic recovery to occur first, in order to let all the fallout from the last crash get purged from the system, before it will be possible politically to implement such a measure. However, sooner or later, implement it we must.