June 30, 2008 | posted by Michael Baxter in House prices |

In yesterday’s Sunday Times, economics editor David Smith puzzled on why house prices were falling so fast.

“I have been puzzling about why Nationwide and Halifax surveys have been showing such sharp price drops, at least as bad as the corresponding stage of the early 1990s slump, when economic conditions are more favourable today,” he said.

Well, fret not.  The reason can be revealed.

House prices are falling today at a pace that is comparable to the levels seen in the early 1990s because they are even more overpriced today.

There are two other key points.

Firstly, one of the key arguments put forward to justify higher house prices in the noughties than in the early 1990s was that thanks to lower interest rates they had become more affordable.     But this was an illusion.  Smoke, mirrors and a good deal of gullibility are the only real differences between the housing market today than in the early 1990s.

Secondly, the economic strength was itself something of an illusion.

Okay, so why is that so.  First the smoke.  This is called inflation.  Higher inflation makes debt more affordable in the long-term.  It appeared that house prices were more affordable today, thanks to lower interest rates.  But actually, over the 25-year period that most mortgages are supposed to last, it seems that they are perhaps more expensive today – as inflation does not erode the true value of debt like it used to.

The mirrors are created by the removal of tax relief on mortgages.  In the early 1990s we are able to reclaim some of our mortgage payments back – it was called MIRAS; you can’t do that today.

The gullibility, well, it is that thing about whenever a bubble is in full sway, we don’t see it.  House prices were rising, for no better reason than they had risen before.   That is called a bubble.

Mr Smith argued the true cause of the property downturn is a shortage of credit. As if the credit crunch was some kind of external factor that had nothing to do with what had been going on before.

But, as was argued in the article above, the fundamental problem with the UK has been a saving ratio which is too low.   This hid the true underlying nature of the UK economy.

When saving is too low, there is insufficient money available to fund borrowing. 

This is why we have a credit crunch, and this is why our banks are having to go to sovereign wealth funds, from countries that have much higher savings ratios.,

So, rather than see the credit crunch as some kind of external shock, it seems far more likely that the factors that caused the credit crunch are in fact the factors that resulted from the inevitable unwinding of the unsustainable boom.

There is one other point.  Thanks to the lower wage inflation we have these days, it takes much longer for rising wage levels to make house prices seem affordable.

So in the past, if house prices were too high, but wage inflation was running at say 9 per cent a year (in 1990 inflation was 9.5 per cent), then in no time the lack of balance was corrected. 

It is not like that now.  House prices were too high, and unless they crashed, they would remain too high for years, as wages only very slowly rose to close the gap.   

It was always inevitable that at some point during their period, some economic crisis would bring everything to its head.

PS  News in this morning from the Bank of England revealed yet another fall in mortgage approvals, this time to 42,000 in May from 58,000 in April.  Approvals are now 37 per cent of the level seen a  year earlier, and way below the low point seen in the early 1990s.  Capital Economics said: “At face value, approvals are now pointing to house price falls of 15 per cent to 20 per cent this year.”