Bubble trouble? Threat of inflated housing sector tempts Bank of England to tighten credit

LONDON—Is Britain’s economy heading for bubble trouble?

Concerns are mounting that the country’s housing market is overinflated, with London house prices rising almost 19 per cent in the year to April. Bank of England Governor Mark Carney has described the situation as the greatest risk to the economy. The International Monetary Fund is worried. Ditto European Union officials.

The pressure is on to act now rather than risk having it all come crashing down later, dragging Britain back into recession. A Bank of England committee set up in the wake of the economic crisis to ensure financial stability is widely expected to take action Thursday to cool the market.

The move will be of interest globally, as its outcome will shed some light on how much a central bank can keep a specific sector from overheating without putting the brakes on the economy as a whole.

“This may not be the mother of all house price bubbles, but it may be the sister,” said David Blanchflower, a former member of the Bank of England’s Monetary Policy Committee who now teaches at Dartmouth College in New Hampshire. “Does it make any sense for the economy? The answer has to be no.”

Driven by interest from wealthy investors, an improving economy and pent up demand in a country with a chronic housing shortage, house prices rose 18.7 per cent in the capital and about 10 per cent in the rest of the country in the year ending in April, according to official statistics. That far outstripped the 0.7 per cent increase in wages including bonuses during the same period.

That means Britons have to borrow more to buy a home. Homeowners in Britain often get new mortgage loans every two or three years to take advantage of fluctuating markets—rather than a fixed longer-term system common in the United States. Carney recently described over-extended borrowers as a threat to the financial system, largely because households make up the bulk of domestic borrowing.

“History shows that the British people do everything they can to pay their mortgages,” Carney said in a speech this month. “That means cutting back deeply on other expenditures when the unexpected happens, potentially slowing the economy sharply.”

Figures from the Organization for Economic Cooperation and Development, a policy watchdog for the 34 most developed countries, suggest property prices in Britain are about 30 per cent too high when compared to wages. In the United States, by contrast, most homes are valued correctly while Japan remains the cheapest market among OECD members after years of deflation.

The froth can be seen in the explosion of real estate agents. In a country where neighbourhood retail shops often struggle to survive, engineers—have little hope of buying a home, especially in the average house price—at about 340,000 pounds ($578,000)—costs 11 times gross average earnings, according to the Lloyds Bank Affordable Cities Review.

Take the experience of Daniel Philpott, 35, of London, who has been sleeping on the sofas of friends and family for two years in hopes of saving enough money for a down payment. He makes 40,000 pounds a year designing air conditioning units for commercial buildings. If he had to pay rent, there would be no hope of saving enough to buy what he wants: stability for the future.

“These high prices are just completely untenable,” he said.

If things reach a breaking point, experts fear a brutal correction like the one that hit the U.S. during the financial crisis, leaving millions of homeowners with properties that are worth less than their mortgages.

Brian Green, an independent analyst who blogs under the moniker Brickonomics, suggested that while people recognize the situation is out of whack, fixing it is another matter. That’s because the problems are complex, and vary greatly depending on region. London’s market, where rich speculators, often from oversees, are buying homes as investments rather than places to live, is nothing like that of some of the struggling cities in the north.

“You have an awful lot doctors at the bedside wondering what the problem is,” Green said. “And clearly there are a lot of different views about what the correct medicine is.”

Central banks have traditionally raised interest rates to try to cool off overheating parts of the economy. But that can be a blunt instrument, hurting other sectors of the economy that are still recovering from recession. Carney is aware of the danger, saying rate increases are still months away.

That leaves the Bank of England’s Financial Policy Committee to try new measures.

Economists say it could recommend tougher affordability tests for potential homebuyers or require banks to hold more capital against mortgage lending. The committee can also recommend a loan-to-value cap, forcing borrowers to come up with bigger deposits. It could also ask the government to rein in a program called Help to Buy, which tries to help first time buyers buy property.

Carney has made it clear he’d rather intervene before there is trouble, having learned from the financial crisis.

“When you hear the thunder of the falls, it is wise to get off the river,” he said.

Bob Pannell, chief economist at the Council of Mortgage Lenders, believes Carney will be looking to the future after extolling the virtues of early action. Even so, any action is likely to be measured and gradual.

“You want to apply the brakes,” he said. “But you don’t want to fly over the handlebars.”