Martin Wolf: A housing disaster in the making

Two days ago I arrived at Heathrow airport from Germany. I found that two moving walkways and an escalator were out of order; the luggage took 50 minutes to arrive; two lifts to the Heathrow Express were broken; and my train had to be cancelled because the doors would not close. From my landing to departure for Paddington took a little short of two hours.

Such experiences make statistics showing the UK's output per hour at well below levels in the advanced continental countries more believable. Is it possible, I wondered, that even the UK's booming economy is a mirage?

When such thoughts cross my mind, I know where to turn. Andrew Smithers, of London-based Smithers Co, can be relied on to puncture any complacency. A report he published a month ago does a good job.*

The starting point is fiscal policy. The probability is that the output gap - the extent of excess capacity in the economy - is now small. The latest Economic Outlook from the Organisation for Economic Co-operation and Development suggests that it will disappear this year. Yet the public sector's borrowing requirement is forecast at just under 3 per cent of gross domestic product in 2004-05. Moreover, this figure excludes what the Smithers report refers to as "Enron-style" accounting of the private finance initiative and the cash deficit of the rail network, which has, in effect, been renationalised.

More important, the fiscal position is vulnerable to adverse shifts in the structure of the economy. Soaring asset prices increase revenue from stamp duty and taxation of capital gains, corporate profits and personal incomes. Lower savings rates also raise revenue, since spending is taxed, while savings need not incur any taxation at all. Today house prices are at a historic peak in relation to household incomes, while equity prices are also high. Moreover, the household savings rate is running at only 5 per cent of disposable incomes, while net household savings are close to zero.

If desired savings were to rise, there would be an economic slowdown and a structural deterioration in the fiscal position. It is even possible to envisage the combination of a recession with a cyclically adjusted borrowing requirement as large as 4 per cent of GDP. The policy instrument left would then be lower interest rates. But imagine a sterling collapse, as the shine went off the UK economic miracle. With a strengthening world economy, robust oil prices and limited excess capacity, the Bank of England's ability to cut rates could be quite limited. Moreover, with a weak housing market, the impact of lower interest rates on the economy would also be impaired.

Why might sterling collapse? One reason is that the currency is especially high, particularly against the US dollar. It is 37 per cent higher, in real terms, than three decades ago, with more than half of this appreciation in the last three years.

The second reason for sterling's vulnerability is the current account position. The recorded current account deficit is running at only about 2 per cent of GDP. But this flatters the true picture, because foreign-earned profits of resident companies are assumed to be 100 per cent remitted to the UK, while only dividend income from portfolio investment is assumed to be remitted abroad.

After making an adjustment for this, the report sets the UK current account deficit at about 3 per cent of GDP. Moreover, net investment income, which has been running at 2 per cent of GDP, is volatile: in the late 1990s it briefly even became negative.

The pessimistic story then is that underneath the economy's glittering exterior lies the usual rotten foundation. When the bubble bursts, consumption will slow, the structural fiscal deficit jump and sterling tumble. The Bank of England will be caught between the inflationary rock and the recessionary hard place.

How plausible is this report's pessimism? Rather more than I would like, is the answer. As I argued two weeks ago, past stability may have encouraged not just households but even the government to assume more risk. I would not regard the Smithers' gloom to be the most likely outcome, but the higher house prices go the bigger the danger becomes. For that reason, the Bank was right to raise interest rates today and would almost certainly be right to do so again. Some prevention is better than all cure.

Solon, the Athenian law-giver, told Croesus, King of Lydia, to count no man happy until he had died. In the same vein, I have learnt to count no British economy healthy until a house price bubble is over. I remain hopeful that the economy's stability will last. If house prices continue to rise at the frightening rate of close to 20 per cent a year, my optimism will vanish.

* "Sterling, House Prices and the Next UK Recession", Report No.216, info@smithers.co.uk

martin.wolf@ft.com

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