Can a crash be averted?

Benjamin Franklin famously observed that "in this world nothing can be said to be certain, except death and taxes". In the context of the economy, this could be recast as nothing being certain, except that housing booms will turn to bust - at least if headlines are anything to go by. In fact, few things are more uncertain.

Over the past six years the media coverage has swung from housing boom to bust, and back to boom, with shameless regularity. This week has been no exception. Predictions of 15 to 30% crashes in house prices have hit the headlines. Meanwhile, the housing market seems to go from strength to strength. According to the Nationwide building society, house prices have risen by a staggering 150% since 1996. And they are still rising at roughly 10 times the rate of inflation.

The one thing that everyone agrees on is that the pace of house price rises cannot go on. What is less certain is how painful the correction will be, when it will start and how long it will go on.

The pessimist's case goes like this. The past six years have seen prices pushed to unprecedented levels in relation to average earnings - the best long-term guide of housing affordability. The chart (right) shows that prices are now at close to seven times the level of wages, the highest ever, easily surpassing the peak of the late 1980s, and significantly higher than the long-run average.

The message from history is clear but bleak. The relationship between house prices and average wage growth has tended to be stable over time. In technical jargon, the relationship is "mean-reverting", that is to say that deviations from the norm correct over time. And that correction tends to come through lower house prices, rather than higher wages.

Based on the Nationwide's data, that implies a fall in house prices of about 35% to bring the "house price to earnings ratio" back to its long-term average level. In fact, the keen-eyed will notice that in the past such corrections have tended to overshoot. If the experience of the early 1990s were to be repeated, the fall in house prices would be closer to 50%. Such a decline would almost certainly push Britain into its first recession since the last housing crash.

By contrast, the case for a soft landing was set out by Professor Steve Nickell, a member of the Bank of England's interest rate committee. Prof Nickell has argued that the surge in prices and the associated build-up of debt has been a rational response to historically low interest rates and inflation.

He also drew comfort from the fact that, looking at a number of potential distress signals such as repossessions, mortgage arrears and the burden of debt, there seems little cause for alarm. All are at historically low levels. Now, argues the bank's monetary policy committee, as interest rates rise, house price inflation should slow towards zero in two years.

So, panic over? Not quite. The MPC forecast would still leave house prices at an elevated level. It implicitly suggests that the sustainable level of house prices has risen, relative to the past.

Low nominal interest rates do not justify permanently higher prices. This is an illusion. But lower interest rates, after adjusting for inflation, could justify higher prices. Real interest rates are lower now than they have been for nearly 20 years. And if that were sustainable, it would argue for a permanently higher house price to earnings ratio.

But there are problems with this argument. The first is that other factors have worked in the opposite direction. Most notably, the tax treatment of housing is far less favourable than it was in the late 1980s. Hence, the real effective mortgage rate on our calculations does not appear to have fallen by much since the early 1990s, and certainly not by enough to justify the present prices-to-wages ratio .

But a real source of concern is that the market continues to defy the MPC and other forecasters. It is showing scant signs of cooling. The MPC has been forecasting a slowdown for about two years. Its policy of interest rate increases appears to be having little effect. Just as was the case with the dotcom boom of the late 1990s, the longer a boom lasts, the more people believe that it represents a new reality, and the more dangerous it becomes.

That misplaced confidence manifests itself in the nature of the debt being taken on at record rates. Despite two rate rises since November and warnings of more to come, 72% of new mortgages in the past three months have been on a variable rate basis. The implication is that borrowers do not expect to see much higher interest rates.

Having presided over the build-up of this debt mountain, the MPC is wary of bringing it crashing down. But gradualism and prevarication may do more harm. It is this associated build-up of debt against a fickle asset price like housing, rather than the rise in house prices per se, that represents the greatest economic danger. House prices may fall, but debt levels will not.

What should be done? As the joke goes, you wouldn't start from here. But here is where we are. The MPC has belatedly stopped trying to talk down the wave of debt, and is taking steps to shore up the economy's defences against a violent correction. It should consider stepping up its gradualist campaign and, for the first time, raise interest rates by 0.5% next month. That may not be popular, but if it averts a crisis, few will complain. Hopefully, it is not too late, but I would not bet your house on it.

· Danny Gabay is a former Bank of England economist, and is a director of Fathom Consulting

danny.gabay@fathom-consulting.com