Time to cool the housing market, before it all ends in tears

NOT for the first time, Britain is experiencing a classic bubble in the housing market. When it bursts, as it surely will, it is bound to cause grief not just to the people who have chosen to trust their future security to bricks and mortar but to the stability of the whole economy.

Figures from the Nationwide suggest the cost of residential properties has grown by an astonishing 16% over the last year and by 90% since the recovery took hold six years ago.

Policymakers at the Bank of England and the Treasury have been extraordinarily complacent about this boom. At a time when manufacturing and exports have been at a standstill, the strength of the housing market and consumer spending - which closely follows confidence in residential property - has looked like a godsend. It has fuelled economic expansion while the rest of the world has been collapsing after the slump in world trade, the economic aftermath of 11 September and the brutal end to the technology fad.

The problem is that the hardest moment to gainsay that a nation is experiencing a bubble is when one is in the middle of it. Herd instinct takes control. On the other hand, there is no mystery about why the housing market is being driven to unsustainable levels.

Base interest rates, at 4%, are their lowest for 40 years which makes possible the servicing of ever bigger home loans. Moreover, fierce competition for business among banks and building societies has made it easier and cheaper to obtain almost unlimited credit. This has led the chairman of the City watchdog the Financial Services Authority, Sir Howard Davies, to warn of a potential calamity.

At the same time, serious savers and investors, disappointed by the fall in share prices and disturbed by the uncertainty surrounding private pensions, have turned to the housing market as a safe form of savings. 'Buy to Let' has therefore become the new credo of estate agents and financial advisers. But not all these properties will see the same appreciation in values. Indeed, the finances of many of these deals are based upon the assumption of low interest rates and low maintenance costs - neither of which can be expected to last over the longer haul.

Some analysts argue that the surge in prices and the expansion of the size of mortgage loans doesn't matter because the ratio of house prices to average earnings, although rising, is well out of the danger zone.

But new data from the respected City firm Capital Economics gives a different picture. It shows that the house prices to earnings ratio is now 31% higher than its long-term average and that at current levels the ratio across the nation is just 2% below the dangerous 1989 level. The picture is even more worrying in London, where the average age of first-time buyers has risen to 34 because of the difficulty in getting on the housing ladder.

It is estimated that if the pace of house price expansion continues, the whole of the United Kingdom could pass the 1989 house prices to earnings ratio mark by September.

Capital Economics fears that if the Bank of England's monetary policy committee does not act soon to slow prices, then the downward adjustment - which is inevitable - will 'result in a crash rather than a gentle slowdown'.

This view has been echoed by two of the great global forecasting groups - the Washington-based International Monetary Fund and the OECD in Paris. They have warned that Britain's housing and consumer boom cannot continue unchecked and that the Bank of England must raise interest rates soon.

In addition, Martin Weale of Britain's National Institute of Economic and Social Research has disagreed with the Bank of England's Deputy Governor, David Clementi, who has rejected the need for higher interest rates. He says house prices are forecast to rise by at least 6% a year while incomes will only grow by 4.5%.

Given this mismatch, no one could be happy with the result of housing becoming 'more and more expensive'.

At the heart of the dilemma is a serious imbalance in the economy. The Bank of England does not want to raise interest rates for fear it might kill off the green shoots of recovery being witnessed in the manufacturing and export industries. Higher rates would also infuriate businesses, which are already in a hostile mood following the Budget which burdened them with the cost of modernising the NHS.

There may now, however, be no alternative. Unless interest rates are soon raised gently in an effort to cool the housing market, they will have to be raised even higher at a later date. This, or some external shock like conflagration in the Middle East and surging oil prices, will make the correction in property prices even more sudden and severe. And finally, a word of warning; financial panics have a habit of arriving when you least expect them to.