Anyone Feel Like Hiking?

At the time of writing the Monetary Policy Committee of the Bank of England is busy deliberating as to whether to raise the base lending rate (currently at 4.5%). The consensus view is that the rate will go up a quarter point. Others speculate on a half percent rise (the National Institute of Economic and Social Research – NIESR – is even advocating this). Of course there is always the possibility that the rate will remain unchanged.

Whatever the speculation about the final decision, there is little mistaking the key factor in the decision: the Uk housing market. The centre of debate is really whether the UK housing market has peaked, or whether more rate raising is needed to bring the market back into line with reality. This is a classic bubble bursting situation.

On this topic the NIESR has no doubt: last week they indicated that on their view house prices needed to fall by about 30 per cent to return to their true value. To bring house prices back to their equilibrium level they advocated one remedy: let the housing market crash.

The FT quotes Ray Barrell, senior research fellow at the institute, as saying ?The Bank is worried about putting up interest rates too hastily because of the effect on the housing market and consumer demand. But if you have a boil it’s better to lance it earlier rather than later.?

So the boil may be lanced. But maybe it already has been. This is the difficult question. Rate changes are notoriously ‘lagged’ in their impact on real economic activity. So today’s decision will not be an easy one.

But whatever it is, one thing seems clear: one day or another the UK housing market will crash. Even if the NIESR are right about the 30% overvaluation, there is no guarantee that any crash will be limited to a 30% fall in values, there will probably be the problem of ‘overshoot’ before the market finds its level.

And what will be the impact of such a crash on the UK economy? Only time will show.

One little commented aspect of this situation is the comparison between the EU’s two ‘housing bubble’ economies: the UK and Spain. One is in the eurozone, the other isn’t. One has the ability to set its own rates, the other doesn’t. The UK rate is already 2.25% above the ECB one. Spain still has the 2% eurozone rate set by the ECB (which isn’t expected to change today). Yet Spain has a housing boom every bit as dangerous as the UK one, yet they are virtually powerless to deo anything about it. Which will end better (or worse, if you prefer it that way)?

Will there be lessons here for the single currency question when the cost of the broken plates is counted up. I suspect there will be. But then, as ever, the future is an open question.

This entry was posted in A Fistful Of Euros, Economics: Currencies by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

17 thoughts on “Anyone Feel Like Hiking?

  1. Yet Spain has a housing boom every bit as dangerous as the UK one, yet they are virtually powerless to deo anything about it.

    Is Spain’s housing boom as a regional variation within the Eurozone significantly greater than the broad regional variations in the stirling-zone?

    It is ironic that Spain’s property boom and somewhat smaller booms in Southern France, Greece and Portugal are being fuelled by Brits taking advantage of the capital gains on their home properties to get “cheap” holiday and retirement homes in the sun. Often buying from Germans who did the same ten years ago but can no longer afford the luxury. An immobiliere friend of mine on the Cote d’Azur was complaining about this last week, she said: “…all the fun is gone, these British don’t even try to negotiate, they just pay whatever we ask.” C’est la vie.

  2. “significantly greater than the broad regional variations in the stirling-zone?”

    I take it that this is a somewhat ironic reference to the situation of Wales, Scotland, the North of Ireland (Yorkshire?) :), and not to those currencies tied in their valuations but not their domestic interest rates to the Pound Sterling and the decisions of the BOE.

    In this case the point is that the UK is one single economy, and the eurozone is not. The reasoning behind this is pretty technical, but at the end of the day a lot of issues about the future of the eurozone hang on these technicalities.

    “It is ironic that Spain’s property boom and somewhat smaller booms in Southern France, Greece and Portugal are being fuelled by Brits taking advantage of the capital gains on their home properties to get “cheap” holiday and retirement homes in the sun.”

    This is surely true, which means the ‘boil’ that Mervyn King is lancing will also probably set off the ‘lancing’ process in the Southern European economies you mention too. Interesting set of interconnections here. Let’s wait and see what happens.

    BTW: my feeling is that the boil is probably already effectively lanced by the previous hikes, and we are only now waiting for this to work it’s way through. Maybe yesterday’s hike was a mistake. Time will tell.

  3. “Update 2: the ECB, as predicted, left rates unchanged. Reasoning: stagnant growth poses a bigger threat than inflation.”
    Looks sensible in my non-economist eyes, not to you?
    As a politician I am inclined to look for other routes to temper the bubble then through the interest rate. Stimulating building maybe?

    Beside that, to me all bubbles (houses or assets) are related to greed and the reversal of the equalization of incomes.
    In the Netherlands all of the judicial system is threatened to be overloaded by claims from people buying assets with borrowed money. When the asset-bubble burst they lost a lot of money and now they claim they were misinformed by the companies lending them the money.

  4. Edward: … a somewhat ironic reference to the situation of Wales, Scotland, the North of Ireland (Yorkshire?) 🙂
    For once any irony was accidental though, yes, my question is: as any broad use of a currency is going to have to cope with regional variations, what is so special about Spain’s housing boom in the EU vs., say, a local boom is the US? Surely American States effectively constitute different economies in the same manner, though not perhaps to the same depth, as European countries. As “c” says: where is the line drawn?

    PS. Mervyn Kings’s boil has gone right over my head – so to speak…

  5. c, Michael,

    I reckon that Edward is thinking about government use of taxes and subventions to transfer wealth from one part of the zone to another. That is factible in the UK, and the USA, but not in the EU, at least on a commensurable scale.

    DSW

  6. @ Michael:

    There exists an entire economic theory covering the topic of “optimal currency spaces”.

    The basic argument is, that, the more certain regions are economically synchronized, the larger the benefits of a single currency.

    Concerning the US economy:
    In the USA there are, as I understand it, tremendous regional differences in how they are affected by individual economic impacts.
    The great US advantage over much of the Eurozone is the far greater flexibility of the “factor markets”, in particular the job market.

    When economic desaster hits for instance Oklahoma (but not the rest of the USA), the wages in Oklahoma go down and/or people move to other states. As a result, unemployment does not rise as dramatically as it would in Europe:
    When economic desaster hits – for instance – Germany, people tend much more than in the US to stay where they are plus the wages don’t go down as fas as necessary.
    Result: Higher unemployment than would have been the case with the DM-currency.

    To sum it up:
    The fatal contruction error of the Euro is that the European labor markets are not flexible enough to compensate for the lost flexibility in exchange rates.
    The ill-begotten “stability pact” tends to make matters worse by forbidding national governments to use the other possible (though less efficient) steering instrument, that ist fical spending.

  7. IIRC about 1% of Spain GDP is from EU money, but that’s about all that the EU can do with its current budget. If I’m not wrong the total budget for the whole of EU operations, subventions, etc. is under 1.5 % of the EU GDP.

    If I understand correctly the economists point of view, that was fine in the past since each state could act on interest rates independently of the rest of members, as the UK is doing, but, since the coming of the Euro, the integrants of Euroland share the same basic interest rate, and since our economies are not fully synchronics, the rate that is best for Germany may be too low for Spain. To handle that the Euroland states should have a tighter fiscal union.

    DSW

  8. But whatever it is, one thing seems clear: one day or another the UK housing market will crash

    They also predicted something like that for the Dutch housing market. That didn’t happen. A shortage of new construction, and low interest rates kept the house prices up since the end of the bubble in 2001.

    The currently predicted doom can easily be reversed by a growing economy. But then maybe not. Doom remains the favourite option for future tellers. Unless they want to sell you something.

    How do economists square these predictions with the theory of markets? Wouldn’t price in efficient markets adapt faster than the NIESR can do their research, and thus make these predictions essentially useless?

  9. A lot of things (like defense and space) are not on the EU budget so that 1.5% of GDP is bigger than it looks.

  10. “They also predicted something like that for the Dutch housing market. That didn’t happen. A shortage of new construction, and low interest rates kept the house prices up since the end of the bubble in 2001.”

    There is still a chance it will come. It’s not so very dangerous in the Netherlands however. Unlike in the USA (I don’t know about Spain and the UK) the mortgage contracts in the Netherlands have very long terms. So when the prices fall people are going to have trouble selling their houses but there is no immediate problem of not being able to pay for the mortgage when the interest rises. The US has timebomb ticking there (if the report from a Dutch bank I read about it was correct) threatening stability.

  11. “There is still a chance it will come. It’s not so very dangerous in the Netherlands however.”

    I agree with Frans here. I think the extent of the bubble in Spain and the UK is just not widely appreciated. We are talking of housing costs rising at around 20% a year over several years. This is madness and unsustainable. It bears no relation to the movement of real incomes.

    It is all being financed by borrowing off a supposedly brighter future. The end product will be indebtedness. Probably the biggest difficulties will come in the banking sector, which has been financing all this.

    As I have said, I think the boil is effectively already ‘lanced’ and the consequences won’t be long in making their presence felt.

  12. “As “c” says: where is the line drawn?”

    In life and not in theory as they say.

    Perhaps one of the criteria could be a cultural one, that people feel they belong to the same economic unit. That there is a sense of social solidarity across the board. East Germany is part of the German economy (despite all the difficulties) in a way in which Italy and Greece do not form part of one Euroland economy.

    There are sovereign states which contract debts, for which none of the other sovereign states are liable (or is Brussels going to shell out for the Italian or Belgian states if and when they go bang?).

    There is one central revenue authority, which plans resource allocation across the zone.

    There is one hegemonic labour market (despite all the imperfections), one social security system, a common pensions and health platform. Lots of things. But above all I would say a relatively common culture. US citizens feel themselves to be Americans in a way which Eurozone citizens do not feel themselves to be ‘Europeans’.

    Another place you could look might be the consumer confidence indexes, they are pretty autonomous in the European member states in a way which seems fundamentally different from the regional variations across the US states.

    “There exists an entire economic theory covering the topic of “optimal currency spaces”.”

    Quite. And I am sure that by now we are all well aware that there are those who defend this theory, and those who don’t. I guess we don’t need another re-run of all the arguments right now.

    Sometimes theories are just plain wrong. (Remember Argentina and the peso dollar parity?).

    As was once said, theory is grey, and life is green. Intuitively I feel that there is something very wrong with this whole idea.

    But then “les jeux sont faits”, so as the British say “the proof of the pudding will be in the eating.

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