The Budget 2012: Should George Osborne learn from Barack Obama?

This was the question that Larry Elliott asked on The Guardian's Economics Blog yesterday. He was of course referring to fact that the USA has implemented a major economic stimulus package whereas the coalition government here has instead (with the tacit encouragement of the Treasury) been implementing a policy of cuts and austerity. As a result the USA has had falling unemployment for most of the last year whereas in the UK unemployment is still rising. In the USA economic growth is well over 1% and approaching 2%. In the UK it is barely above zero. So has Obama got it right and Osborne got it wrong?

To answer this we must first take stock of what it is exactly that the US government has done. Its stimulus package has in fact been in three parts. First it reduced its short-term policy rate (just as the Bank of England did). Then it introduced Quantitative Easing (QE), just as the Bank of England did. Then last autumn it launched Operation Twist. This involved buying long-dated bonds to bring down long-term interest rates and replacing them with short-dated bonds, but as Operation Twist is such a new initiative can it really be held responsible for a US recovery which has been underway for over a year now? Probably not, and as Larry Elliott suggested in his column, it is difficult to see how Operation Twist could really effect aggregate demand. So is the real explanation for the difference in recovery rates between the US and the UK just down to the size and length of the stimulus. Perhaps not.

Perhaps the real reason that the US economy is growing faster is not just down to the federal stimulus. A point that is too often overlooked has been the scale and the effect of the housing crash in the US over the last four years. Unlike in the UK where house prices fell by only about 20% from their 2007 peak and are still at historically high levels, in many parts of the US the fall has been much more dramatic. Could this be part of the reason that the US economy has seen a better speed of recovery?

In case you had forgotten, it was the boom in the housing market in both the USA and Britain (and Ireland and Spain for that matter) that led to the financial crash in 2007, rather than just a failure of bank regulation. In all of those countries mentioned the housing bubble was the result of either rising inequality or increasing economic imbalances and, in the case of the US and UK, stagnant growth in real wages for the less well off as well. As a result an excess of investment funds got misdirected into creating bubbles in asset prices (i.e. property) instead of being use to create new means of production.

What is different about the US response to the crisis, compared to the UK one, is that the US allowed their housing bubble to implode. We did not. In fact government policy in the UK is still more concerned about supporting house prices than it is about keeping people in work. That is the big mistake. Negative equity is only an economic problem if people start losing their jobs.

In the USA by contrast, by allowing the housing market to crash the policy makers have forced the debt holders to take a "debt haircut" and thus allowed the economy to partially reset itself. Thus the USA has benefited from a combination of a debt haircut and a stimulus. In the UK we have had a weak stimulus primarily for the banks but no haircut. In the Eurozone (e.g. Spain and Ireland) they might get a small debt haircut but no stimulus. Thus it is the combination of stimulus and debt write-off that is the necessary remedy. Those countries that only take half the medicine either take much longer to recover, or don't recover at all.

However it is not just about the size of the stimulus either. It is also about the shape of it. The correct economic response to the current crisis is not just to provide a stimulus, but to direct that stimulus towards correcting the original cause of the problem, namely the housing market. By building more social housing the government would not only have created jobs, it would also have reduced house prices and private sector rents and thereby increased disposable incomes for the majority of families. That would have magnified the effect of the stimulus and helped to eradicate the core problem. Instead we are having to endure an economic policy that protects the haves at the expense of the have-nots. That is just a repeat of the very economic policies that caused the whole sorry problem in the first place.

Home ownership and economic mobility

A couple of weeks ago James Gregory of the Fabian Society published an article on the Fabian Society’s Next Left blog where he discussed the impact of increased home ownership on the economy, and the labour market in particular. The central tenet of the article was that the continuous increase in home ownership seen in the UK over the last thirty years has reduced the capacity of the labour market to respond flexibly to economic changes. Rather than complementing and enhancing the legislative changes introduced by the Thatcher and Major governments that were supposedly designed to liberalise the labour market in this country and increase growth, his argument is that increased home ownership has instead acted, at least partially, to neutralise many of those changes and thereby presumably retard growth.

What I found surprising about the article though, were its starting assumption that most people (or perhaps only most of the current political class?) believe that home ownership increases economic mobility, and secondly what I perceive to be the article's failure to fully describe the true extent of the causes and impact of this immobility. As a result some of what I would consider to be potential remedies were neglected. For by omitting some of the causal factors, it is undoubtedly more likely that some of the most effective solutions will also be overlooked. However what the article does do is once again highlight the negative impact that current housing policy (such that any active policy actually exists in the UK) has on the British economy.

Given the well-known problems of transaction costs (estate agent fees, stamp duty, surveyor fees, re-mortgage fees, conveyancing etc) and the logistical problems associated with the home moving chain, I was more than a bit surprised that "popular opinion" was perceived to be as the article implied. I have certainly never been of the opinion that home ownership may actually make workers more economically mobile. In fact I suspect that most people are not, and do not even desire to be economically mobile. This conjecture is probably borne out by the average time between re-sales for domestic property in the UK (currently about 20 years). You can see the immobilising effect of home ownership by comparing this value with the average length of time most tenants stay in the same property (often for only a few months). Doubtless, much of this difference is due to what James Gregory referred to as "psychological attachment". Homeowners have a lot of emotional as well as financial capital invested in their homes that is generally absent for many tenants.

James Gregory also rightly points to the principal contradiction in UK economic policy: “why have we spent the past 20 years actively pursuing ‘flexible’ labour market policies whilst, simultaneously, seeking to push more and more households into homeownership?” The answer, he claims, lies partly in the myth “that owner-occupation is a vehicle of social and labour market mobility.” It may well be that owner-occupation advances the former. Unfortunately, it most certainly acts against the latter. In addition to the transaction costs described above, there are a number of other reasons why owner-occupation acts to reduce labour market mobility. James Gregory highlighted in particular the pressure some homeowners face to keep up their mortgage payments. Such pressure can often trap homeowners in jobs thereby reducing or removing their ability to change career or relocate. However, I think there are some other pressures that are perhaps even more problematic, not just for the individual, but for society as a whole.

The first is the rise in, and the impact of, double income households. The high cost of housing (both home-ownership and rental) is forcing more families to send both adults out to work. This in itself acts to reduce mobility even more as the probability of both adult partners with different careers being able to find suitable jobs in the same part of the country at the same time is always going to be less than the probability that each will find work independently.

This then leads to a second problem: an increased tendency for skilled labour to cluster in regions of high employment density such as the South East where both partners are more likely to find suitable employment. This in turn leads to greater regional inequality and overheating of some local economies. This positive feedback mechanism then further exacerbates the original effect (i.e. high house prices) that gave rise to the problems of low mobility and employment clustering (caused by a move towards double income households) in the first place.

This clustering then also impacts on employers. Many firms, particularly those that depend on highly skilled labour, have already recognised this problem. As a result they also tend to cluster in regions where the skilled labour is already situated, thus adding to regional inequality. Moreover there is a growing tendency for many of these firms to actively reject job applications from outside their local area because of worries about mobility and relocation problems, thereby adding to the imbalance.

The result of all of this is that regional disparities in house prices are exacerbated. This also acts as a further impediment on labour mobility, at least for those trying to move from poorer areas to wealthier ones.

Finally there are the issues of short-term and part time jobs. These may give employers greater flexibility, but the cost is borne by the worker (and to some extent the State). Just as it is more difficult for a family of two adults to move and find new employment for both of them than it would be for a family with just one wage earner, so it is also more difficult for an individual with several part time jobs to move and replace all of those jobs simultaneously than it would be to replace a single full time position.

These then are some of the additional problems that I would seek to highlight. Unfortunately I can see little reason why the remedies that James Gregory proposes would make much difference. For example, providing more advice and assistance to those with mortgage problems will at best only slightly ameliorate an already abysmal situation. In fact it could actually make the situation worse by giving artificial external economic support to home owners who having inflated the housing market are unfairly supported within it through taxpayer support. What is needed is a set of policies that tackle the underlying problems.

The first of these problems is excessive house prices that force families to work longer hours than is socially desirable and which have wider consequences that are economically undesirable. Until a government commits itself to delivering stable and reasonable house prices this problem will not go away. This requires an economic policy that delivers such stable and reasonable house prices (as I have previously outlined) so that families can reclaim a more socially desirable work-life balance, and more of their disposable income can be recycled within the productive economy rather than being sunk into unproductive fixed assets.

The second problem to be addressed is the issue of regional inequality. For this we need progressive tax rates for employers (NICs, land tax and business rates) that vary regionally and decrease with distance from London. We also need more investment in the regions that doesn't just increase employment, but provides high value jobs. For this we need to look to France and Germany and establish a network of research institutions akin to the Max Planck, Fraunhofer and Helmholtz Institutes in Germany (of which there are more than 150) or the CNRS in France (of which there are over 100 separate facilities). These policies would indeed attract high value jobs back into the regions and do so far more effectively and more sustainably than the current system of regional development grants.

Finally we need to actively reduce the number of part time jobs in the economy. Flexibility is OK in good measure, but the balance has clearly gone too far. There are currently about 1.2 million people working in part time jobs while actively seeking full time positions. Much of this increase in part time working is driven by the way employers' National Insurance contributions (NIC) are levied. Employer NIC exemptions for jobs that pay less than about £110 per week should be limited to companies with less than five employees. The purpose of these exemptions should be to help a very small company take on the one or two extra staff it needs to meet fluctuating demand. They should not be used by large chains of stores to reduce their tax bill. Large companies should already have sufficient employment flexibility by virtue of the size of their workforce. Currently too many are exploiting this tax loophole for their own financial advantage, but to the detriment of the wider economy.

These then are some of the solutions that the Left should be complementing. First, though, it needs to recognise the wider impact that the housing market has on the UK economy. Building more houses, or providing more social housing, is not enough. Neither is simply setting up a few advice networks for distressed home-owners. The problem is much wider and more entrenched than can be solved by such simplistic solutions.

20 questions for the next Labour leader - part 1

Last week Sunder Katwala of the Fabian Society posed the question on the Next Left blog site, "What are the difficult questions the leadership candidates need to answer?". The biggest surprise about this question is that no-one has asked it sooner. Many in the Labour Party who were unhappy with Gordon Brown's leadership may well have acted against him long before the last General Election if there had been a credible alternative candidate waiting in the wings. Unfortunately, one of the reasons that there was no credible alternative (even though there were plenty of potential candidates) was that no-one really knew what any of the possible leadership contenders stood for. The problem now is, we still don't.

There is a common misconception in the media that Labour lost the last election merely because of a failure of presentation, both in its policies and in the personality of its leader. I disagree. I believe Labour lost because it ran out of policy ideas and therefore appeared to many to be a spent political force. After 2001 it had exhausted the stock of policies it had built up in opposition, and any policies it came up with subsequently it had to invent on the hoof while running the country. Unfortunately most of them ended up sounding as though they were made up on the hoof. They lacked coherence and intellectual rigour, and alienated our core support. In fact many of them just didn't work. On top of that there was a total failure to address the issues that affected Labour voters the most (jobs, housing) or angered them the most (bankers bonuses, immigration, the economy). That is why before the Labour Party can choose a new leader, the members need to know where the candidates stand on the issues that matter to them.

Unfortunately, so far in this leadership campaign all we have seen is more of the same. It has been the same bland candidates with the same vacant policy agendas. So far the campaign has been about who has the looks to take on Cameron, and who can amass the biggest army of sycophantic backbench supporters. That is why Sunder is right to ask his question. I have already offered Sunder my initial answer on what those questions should be, but here I will outline my definitive top 20, starting with my top five. The rest will come later.

1) The first question any potential leader should have to answer is the BIG one. It is this: "Why do you want to be leader? "
This is the question that Roger Mudd of CBS put to Ted Kennedy when he ran for US President in 1980. His failure to answer it effectively ended his presidential ambitions. For that reason alone, it is a question that deserves to be put to all leadership candidates. The events of the last ten years demonstrate that if a party is to avoid electoral stagnation, it needs to have a leader with a vision, not someone whose sole aim is to manage things a bit better, or is driven by his own hubris, vanity and lust for power and status. That is the underlying importance of this question.

2) The next question is one that I think follows on naturally from Q1. It is, what is YOUR big idea? What do you see as the fundamental structural problems in British society and what would you do to correct them?

Then we need to get into specifics regarding what a future leader would do if they became PM. If there are three issues that define the failure of the Blair/Brown years, then they are probably the housing crisis, the continuing rise in inequality, and the attack by the last government on civil liberties.

3) Housing
First we need to know if the candidates fully understand the role the housing bubble played in causing this current recession. Do they appreciate the effects that shortages of affordable housing have on distorting the labour market and reducing the mobility of labour? Do they recognise that inequalities in housing inevitably lead to inequalities in health, wealth and education? Do they understand that booming house prices lead to underinvestment in productive industry, and therefore to stagnating GDP and excessive private sector debt? Do they understand that housing booms always end in housing crashes, and that that always leads to recession, or worse? If so, we need to know how they plan to address these problems.
Would they support the building of more Council Houses, or social housing? And if so, how would they ensure that house building occurred in sufficient quantities? More importantly, how would they prevent future housing booms from occurring? I have already argued that control of house price inflation is essential to our future economic growth, and I have already outlined how such price stability could be achieved. If you don’t know the answer then I suggest you look here.

4) Inequality
Despite many noble initiatives, inequality in Britain grew (by some measures at least) under the 13 years of the last Labour government. If the Labour Party stands for anything, then it must be for the promotion of equality and fairness in all sectors of society. I doubt that anything in the last election campaign angered Labour voters as much as seeing David Cameron continually trying to present himself as the new champion of the poor and dispossessed. So any new Labour leader must outline how they would reduce inequality and make Britain a fairer country?

5) Civil Liberties
Despite incorporating the European convention on human rights into UK law, the last government's record on human rights and civil liberties was far from exemplary. Allegations of collusion in torture, extraordinary rendition, unlimited detention without charge and ID cards all made it look repressive and authoritarian. Worse still, it appeared more authoritarian and pro-establishment that the Tory Party. That is hardly a favourable position to be in for a party that claims to be the champion of the working man.
The question then for the leadership candidates (some of whom were associated with many of these illiberal policies) is this. Which should take priority under the law: the civil liberties of the individual, or the right of the state to maintain its own security? To claim (as many politicians do) that one must always try and balance civil liberties against the need for security seems to me akin to arguing that a country should always try to compromise between democracy and totalitarian rule. It can never be about balance or compromise. It is always about principles. It is about which of the two viewpoints should take priority, both in government policy, and under common law. It is also about the balance of power between the establishment and the people: the rulers and the ruled. That is why Labour should always be on the side of civil liberties, because it is about protecting the disadvantaged from abuse of power by the privileged.

These then are the first five questions I would put to the leadership candidates, but they are not the only ones. It remains to be seen, though, if we manage to get any satisfactory answers to any of them.

House price inflation part 2 - a solution

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.

The real issue is house prices, not bank regulation.

This week the FSA published proposals to increase and improve the regulation of mortgage loans, principally by banning self-certification mortgages where applicants were not required to provide any proof of income. At the same time much of the wider political discussion has been about more general regulation of the banking industry. Unfortunately, both this strategy of the SFA and the wider discussion seem to me a bit weak at best. They are both based on the flawed assumption that the current economic crisis was caused by the reckless behaviour of banks and bankers, when in fact it was at least partly caused by an unregulated house price bubble that, together with the securitisation of debt, encouraged bad lending practices. To suggest otherwise is to put the cart before the horse. Banks like Northern Rock, HBOS and RBS did not collapse or require government intervention because they indulged in the reckless trading of derivatives. The problem was they borrowed in order to lend into an inflated property market, and it was the rate of inflation of that market that encouraged them to borrow so excessively.

The issue is this. Fundamentally, there are two distinct problems that need to be solved, not one. These problems are the risky lending practices of banks as they sought to inflate their profits, and the boom in house prices that both underpinned those policies, and was driven to even greater extremes by them. In this chicken and egg world, it is both of these failures that need to be addressed. Unfortunately our politicians and regulators so far only seem interested in tackling the first of these. They are only interested in saving the banks and the financial system while appearing quite happy for laissez faire free-market ideology to go on unchecked in the rest of the economy, and particularly in the housing market. This is partly because in doing so such actions reinforce the current received wisdom that all the current economic woes are the fault of nasty, greedy bankers, and not the way banks and bankers were (or were not) regulated, because obviously if it were the latter then politicians would also have to share in the blame, and that would never do.

So, one year on from the collapse of Lehman Brothers and the almost complete nationalisation of Scottish banking, and it seems it is not only bankers who have learnt nothing from the experience. Listening to the latest proposals from the FSA on the regulation of mortgages, it is clear that most politicians and regulators still haven’t got it either. What is worrying about the latest FSA announcement is not so much the proposals that are being advocated: it is the total disregard for the ones that were omitted. Fundamentally, though, it is about the complete failure to even acknowledge the elephant in the room that still no-one will talk about. That elephant is house price inflation and how to control it. The conventional wisdom is that such control is beyond the power of governments or regulators. I disagree. I believe it is both possible and essential that this rampant source of inflation is killed off once and for all time if we are ever to return to sustainable economic growth, or if Gordon Brown’s dream of no more boom and bust is ever to be realised. Moreover, I will demonstrate precisely how it can be done.

This antipathy towards controlling house price inflation also highlights the hypocracy of our politicians and leading economic thinkers. If economic stability is so critical to ensuring long-term economic prosperity, and if the control of inflation is so critical to maintaining economic stability, why is the control of house price inflation not sought with equal enthusiasm? After all, was it not the housing boom that ultimately caused our current economic problems? And it’s not the first time such a boom has been the cause of recession in this country, is it? So, unless we do something to change things, it won’t be the last either. So why the reluctance amongst so many politicians to do anything to change things?

Maybe the obvious answer is that there were too many vested interests in politics, business and the media that were benefiting from the boom, or at least thought they were. And with so many MPs using their second home allowance to play the property market themselves, perhaps it is understandable that there was little appetite amongst many of them to kill the goose that was (temporarily) laying the golden egg for the privileged few. Yet in 1997 we were told that things would be different. As Gordon Brown stated in his first budget speech as Chancellor: “I will not allow house prices to get out of control and put at risk the sustainability of the recovery”.

The mistake Gordon Brown made was the same one that many others continue to make. He tried to counter house price inflation through taxation. In 1997 he reduced mortgage tax relief and raised stamp duty. Unfortunately neither measure had any effect. Nor could they, because the plain fact is that you do not dissuade people from speculative behaviour merely by taxing a proportion of the profits of that speculation. That is why stamp duty doesn’t work, nor capital gains tax, nor a land value tax. In order to control inflation in house prices you have to get back to fundamentals and control supply and demand.

Many on the Left have been advocating house building as a solution, particularly the building of more social housing. While this supply-side approach would have many benefits, it is also very slow to implement. On average it takes between three and five years for a house to get built, so a supply-side solution will always lag behind the market and will always be playing catch-up. When the market turns, the change will be exacerbated and the boom and bust cycle maintained.

The only viable solution is to control demand. Traditionally governments have done this using interest rates with some limited success, but this approach also damages the wider economy, particularly with regard to business investment. What is needed is a lever that the State can pull that only affects the number of potential house-buyers. That lever is the one that controls the supply of mortgages. If you control this, you ultimately control the number of buyers in the market. Unfortunately, the Government and the FSA have just rejected the two measures that would do just that. As Lord Myners said last week, “...we’re not going to have a mandatory limit on loans to value or loans to income but rather a prudential limit...”

Yet it is only these policies of either a manditory limit on loans-to-value or loans-to-income that can ever work. They can, after all, be defined and quantified objectively within a legal framework. How do you define and quantify prudence? More importantly, however, by setting changeable limits on what people can borrow for a mortgage you can adjust those limits and thereby adjust the qualifying criteria for mortgages as economic circumstances change.

As the deposit required for a mortgage goes up, the number of people who can summon up such a deposit will decline until the balance between buyers and sellers shifts in favour of the remaining buyers. Therefore the price of housing will eventually stop rising and begin to fall. Similarly, if the criterion is the ratio of earnings to mortgage value, reducing the ratio removes lower income applicants from the bidding process for each house and also reduces the eventual sale price. Thus both mechanisms should result in lower house prices and a control of inflation in that sector of the economy.

No doubt the naysayers will ask, how do you know such a policy would work? Where is your evidence? Has it ever been applied anywhere?

Well the answer is yes, right here, right now.

Why do you think house prices have crashed over the last two years?

• Was it because of higher interest rates? No!
• Was it because of higher tax rates? No!
• Was it because of increasing supply of houses? No!
• Was it because of a shortage of potential buyers? No!
• Was it because of a shortage of mortgages? Not exactly.

It was because the banks raised the deposits that prospective buyers needed to provide in order to qualify for a mortgage. A year ago this deposit was so large that most prospective buyers were forced out of the market. The result was that house prices crashed. Now, though, those deposits have fallen from over 20% last year to as little as 5% in some cases this month. And the result? Well over the last six months house prices have been on the rise once more as the buyers have returned. If that isn’t convincing what more evidence do you need?

The problem is that all this has happened by accident, or at least in a haphazard and totally indeterminate manner. Yet it needn’t be so. All that is required is for the Government to give the Bank of England (or some other independent financial authority) the power to set these deposit levels on a monthly basis, in much the same way as Bank of England interest base rates are currently set, and then house prices can be brought under control once and for all.

So if this Labour government is truly interested in delivering economic stability and a fairer society then it must commit itself to the control of house price inflation. Without such a commitment any housing policy it tries to implement in the future will at best be no more than mere palliative care, and any economic policy will ultimately be wrecked on the same rocks that scuttled the last policy.