Comparing bubbles, predicting the crash

During the last 20 years, the UK had the misfortune of living through two huge housing bubbles. The first was carefully nurtured under a Conservative government, while second happened under New Labour. Thus, it would seem that housing bubbles are non-party political beasts.

We see the current house bubble through the prism of the last one. Therefore, it might be useful to compare these two extraordinary periods. Before comparing them, it is important to date them. I will use a simple rule. Over the long term, there appears to be a steady relationship between house prices and average incomes. Historically, this ratio fluctuates between 2 and 3. When the ratio rises above 3.5, I assume that house prices have departed from long-run fundamentals and the bubble has begun.

In the case of the Conservative bubble, this happened in April 1984, and in October 2001 for the Labour bubble. Once I have the starting date, I set the price on that date to equal 100 and then superimpose one price series on top of the other. If I do this, I get the chart below.

Superficially, both bubbles seem similar. In terms of housing inflation, prices increased by 118 percent under the Conservatives, and 113 percent under Labour. The length of both Bubbles is also similar; the Conservative one took 63 months to reach its peak, while the Labour bubble took 70 months.

However, behind the superficiality lie some profound differences.

The Conservative bubble is an easier story to tell. After several years of steady price appreciation, prices accelerated in one last mad burst to the top. Once it reached the peak, inflation was raging and the government ordered the Bank of England to raise rates. House prices then began to tumble for the following 80 months.

The New Labour bubble was more front-end loaded. During 2001-05 price appreciation was extraordinary. By mid 2005, inflation picked up a little, and the Bank of England cut rates. House prices began to slip, and the Bank of England quickly began reducing rates. The policy reversal gave the bubble a second lease of life, and prices increased for a further 2 years.

The differences become much more apparent when one looks at price to income ratios. In the case of the Conservative bubble, the ratio only reached 4 in December 1987, and it peaked at 4.8. Therefore, for long periods, one could argue that house prices were only marginally detached from incomes. At the time bankers and estate agents used this argument extensively.

In contrast, the price to income ratio in the Labour bubble shot up rapidly, passing 4 within a few months, and almost reached six at the peak.

The reason for the different price to income ratios is straightforward. Nominal interest rates during the Labour bubble were much lower, which allowed people to take on much higher mortgages. Interest rates were low, because inflation worldwide was under control.

Real house prices point to another major difference. In real terms, the Labour bubble was larger. During the 1980s, real house prices increase by 60 percent, whereas the most recent bubble, prices increased by over 80 percent.

We can also see how house prices returned to fundamentals once the Conservative bubble finally burst. There was a modest reduction in nominal prices, but most of the adjustment came through inflation. Since inflation and average earnings move together, house prices became affordable because eventually nominal wages caught up. The real adjustment, during the 1990s, was dramatic. From the peak to trough, prices fell in real terms by 34 percent. From the beginning of the bubble in 1984, to the bottom in the late 1990s, house prices increased in real terms by just 10 percent.

What does this tell us about the likely adjustment facing today’s housing market? Today’s prices will need a much higher nominal fall to return the market to a more reasonable price-to-income ratio.

To understand why, it is important to recognize that in the 1980s both inflation and interest rates were well above 10 percent as the bubble burst. The higher levels of inflation ate away at the real value of housing and put a floor under nominal prices. Furthermore, as inflation subsided, interest rates came down reasonably quickly. This also helped cushion the nominal fall because housing affordability improved. Although the market still crashed dramatically, these two effects limited the size of the crash in nominal terms.

Neither of these two effects is present in quite the same way right now. Although inflation is rising, it is likely to fluctuate between 3-5 percent for the next two years. It is not enough to seriously dent the real value of housing or reduce the price-to-earnings ratio over the medium term. Interest rates, and especially mortgage spreads, are now adjusting upwards, reflecting higher levels of risk. As inflation picks up by 1-2 percent, it is likely to put a floor under interest rates and may even contribute to higher rates, and therefore keep housing affordability high.

The 1980s adjustment had other things going for it; a recession, a high repossessions rate, and the sterling crisis. However, I doubt there is much comfort here. In the fullness of time, the UK economy may also produce its own complementary recession, which will push up repossessions and unemployment.

Three things make the current housing market much more frightening than the one in the 1980s. First, it is incredible just how unaffordable house prices are today. The UK average price-to-income ratio is well over 5. In some parts of the country, like London and Northern Ireland, it is approaching 8. Second, personal sector balance sheets are in appalling shape, with many households holding crushing levels of debt. Finally, banks have lent out too much and they know it. They have abandoned the housing market and they are unlikely to return.

It all points in one direction. The UK housing market is facing a massive nominal price correction. As hard as it is to believe, this correction could be much worse than the one in the 1990s.