Free money

Why didn’t someone think of it before? It is so obvious. The logic is so simple. If the housing market is collapsing from a lack of credit, then why doesn’t the government step in and offer free loans to first time buyers. Problem solved. As soon as the money comes on line, house prices will stabilize. First time buyers will come flooding back into the housing market, waving their free loans at risk-averse banks.

How did Brown and Darling justify this extraordinary generosity? In announcing their housing rescue package today, three themes kept cropping up; the first two were explicit while the third was implicit.

Give me the confidence

Confidence was the first theme of the day. With the onset of the credit crunch, Brown claimed that people had lost confidence in the housing market. Banks, buyers and sellers were all trapped in a crisis of self-doubt and uncertainty. Banks wouldn’t offer credit; buyers without credit could not make viable offers, while sellers had not reconciled themselves to lower valuations. The government’s housing package will put a floor on prices, this would buttress confidence, and gradually things would return to “normal”.

Help the home buyer

First time buyers were the second prominent phrase of the day. The government package intended to clear the path for those starting out on the long road to property ownership. Hazel Blears was on the TV this morning, talking like an estate agent. She told viewers that the new measures would allow young people to get a footing on the property ladder.

Housing inflation equals economic growth

The third big idea was rather more implicit. No one said it directly, but hinted that the economic growth depended on a thriving housing market. Kirstie Allsop came closest to pointing out the connection on Radio Four Today, when she offered support for the government’s plan. She pointed out that without housing transactions, people stop buying white goods; furniture gathers dust in the storerooms, while plumbers and builders remain unemployed. Therefore, the revival of the housing market is essential if the UK economy is to keep on growing. This theme can be expressed in starker terms; we all benefit from housing inflation, even those who are priced out of the market, because housing bubbles hold up economic growth.

Ineffective, costly and possibly both

None of these themes can withstand thirty seconds of serious scrutiny. Take, for example, the confidence and the government’s capacity to hold up prices with free credit.

In order to stabilize the housing market, the government would have to offer massive amounts of free money. A few simple numbers will prove the point. Between March and July this year, the total outstanding amount of mortgages outstanding owed to Banks fell from ₤559 billion to ₤546 billion – shortfall of ₤13 billion. Assuming a five percent interest rate, the government would need to supply ₤650 million in order to make up the shortfall in just four months. Simply put, the free loan scheme will either be ineffective or astronomically expensive. It might also be both. However, it will not put a floor on house prices because the government does not have the resources to supplant bank credit.

Will it help first time buyers? It might help a few, but the vast majority will be left worse off. Suppose the government offered ₤30,000 interest free loans to 20,000 home owners, the government would need to supply ₤600 million worth of credit. The number 20,000 represents one month’s shortfall of mortgage approvals this year relative to 2007.

To put it mildly, 20,000 doesn’t really begin to cover the number of bitter people who have been shut out of home ownership due to the bubble. Besides, first time buyers were receiving huge assistance from falling prices. It is hard to see how stabilizing prices at the current inflated levels helps anyone trying to buy their first house.

Turning to the third, implicit theme; does the UK economy need the housing market so badly that the government should try to subsidize grotesque house prices with free credit? Are we really that dependent on inflated property values? These are the wrong questions to ask. A better one would be how should the government act to unwind the UK’s extraordinary vulnerability to its property market? It is a difficult question, and it is hard to see an answer that does not include some kind of significant slowdown in economic activity. Since this question only offers difficult answers, the government prefers to hide behind a seemingly simpler task of holding up property prices.

Get prices right and everything will be alright (eventually)

The first crucial step towards solving any economic problem is to get prices right. Once effective demand equals supply, incentives are properly aligned, and markets will perform reasonably well. If any government interferes and sets up a policy based on sustaining misaligned prices, then it is only adding more difficulties upon the existing pile of problems. House prices are misaligned from long run fundamentals. In order to purchase a house today, home buyers need huge loans that place an unbearable burden on long term personal finances. Banks are no longer willing to supply credit because they have finally come to realize that default risk has risen to unacceptable levels.

Delaying the inevitiable

New Labour is unwilling to recognize this reality. Instead, it offers another misaligned price; zero interest loans in order to sustain overpriced property prices. Brown and Darling can harp on all day about confidence, help for first time buyers and the weakening economy. This package will only delay the inevitable.