Boom's foundations are on the brink of subsiding

Take one small island. Add a large population. Stir in some tight planning laws. Top up with interest rates at their lowest level for four decades and what do you get? You don't need to be a trained economist to come up with the answer: an explosion in house prices.

The laws of supply and demand guarantee that over time, the cost of property not only rises in the UK, but increases more rapidly than the overall inflation rate. There are times, such as the early 1990s, when the prices of homes fall, but these tend to be few and far between. Demographics, green belt laws and an ingrained faith that bricks and mortar is the best investment see to that.

But as with all markets, the price of houses does not rise in a smooth, predictable manner. Buyers get carried away. They show irrational exuberance. They borrow more than they can afford in the belief that the good times will go on for ever. They forget.

Right now, Britain is experiencing amnesia on a colossal scale. There are plenty of warning signs that the boom in house prices is a bubble waiting to burst, but they are being systematically ignored. The record 3.4% jump in house prices reported by the Nationwide yesterday is no one-off. Mortgage approvals for transactions in the pipeline point to the normal spring surge in activity continuing through the summer.

This may make interesting dinner party chat for those sitting pretty on a massive capital gain, but it poses two big problems.

The first is that first-time buyers are being priced out of the market. In London and the south-east, where the property boom has been strongest, the strains on the public sector are becoming acute as teachers, nurses, bus drivers and refuse collectors find they cannot afford the asking price for even the most modest property. In the private sector, bars, restaurants and shops are finding it difficult to find staff.

The second problem is that the market will collapse, either of its own accord or because the Bank of England decides that enough is enough and raises interest rates. David Clementi, the Bank's deputy governor, said earlier this week that lower interest rates meant that current levels of mortgage debt did not appear "excessive".

The basis for this argument is that interest rates are much lower than at the end of the 1980s, when base rates were left at 15% for a year to kill off the housing-led inflationary boom of 1988.

But Roger Bootle and Paul Dales of consultancy firm Capital Economics warned yesterday that with interest rates at a low level, even a small increase in borrowing costs would have a big impact on the affordability of housing.

They estimate that affordability - the ratio of house prices to average earnings - is already a cause for concern. Using the government's figures for house prices, they calculate that the ratio of prices to earnings is only 2% below its all-time peak in 1989. In London it is already 8% above its peak.

It is only a matter of months before housing becomes more expensive than it has ever been. Crunch time will be when the Bank decides it is time to tighten policy.

"The overall message is clear - a significant slowdown in house price inflation is on the cards," said Bootle and Dales. "This could happen smoothly, but the longer the current bull run continues, the greater the danger that the market will see a crash rather than a gentle slowdown. Caveat emptor!"