Why house prices aren't all they seem

If you'd asked me in 2007 where UK house prices would be by now, I would have told you that they'd be down something in the region of 20-30%.

They were far too high relative to wages and rents, a credit crunch was kicking off and the mortgage market was bound to tighten dramatically just as real incomes fell. How on earth, I would have said, could house prices not start reverting to their mean in circumstances like that?

I said the same thing about the US. It worked out pretty well there so much so that last year I suggested we all start looking to buy houses in Florida. Would that I had followed my own advice...

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However, it hasn't worked out here. The bubble did end but not with much drama. London has held the national average numbers up nicely: the Nationwide index suggests average prices are down around 11%. Break it up into the regions and it looks better (for me, at least).

Prices are down over 50% in Northern Ireland, 14-16% in most northern parts of the UK and 8-10% in the south. And if you take inflation into account, my dire forecasts look better. Prices across the UK are down about 27%. In real terms, prices in the north are down 27-30% and those in the south 20-24%. Even Greater London prices are down 15%.

The problem is that in this cycle, falling real prices haven't helped affordability as much as you might think, because real wages have been falling too.

Price-to-income ratios have improved mildly because real prices have fallen more than real wages. The Lloyds TSB Affordable Cities Review shows city ratios down to an average of 5.6 times earnings against a bubble peak of 7.2 times. In Londonderry, prices, at 3.4 times earnings, are back to just below the UK long-term average of about 3.5 times.

In Oxford, however, houses still costten times average earnings, and in the majority of other places, there's some way to go for mean reversion to have run its course. It is also useful to note, as Lombard Street Research has, that, historically, the deposit required of a first-time buyer in the UK is 30-50% of salary. It is currently more like 100%. Mortgages might look cheap, but buying a house isn't.

So why does everyone seem to think things are picking up nicely? Transaction levels and buyer interest levels are both reported to be rising slowly; nominal house prices rose 1-2% in the 12 months to February; and PR companies have once again started sending out nonsense press releases I got one a few weeks ago suggesting that houses in streets starting with "U" are the best investments.

All the happy talk is largely down to that master of market distortion, the government. I like to think that the coalition occasionally thinks of something other than house prices, but anyone looking at its policies wouldn't be so sure.

Interest rates remain at their lowest for over 300 years; the Funding for Lending Scheme is chucking out cheap money; and for those who can't even afford to buy under these circumstances, there are shared equity schemes and Help to Buy, a massive mortgage guarantee scheme.

The upshot is that everyone who buys a house in the UK with debt is effectively supported in doing so by the government.

That's nice for would-be distressed mortgagees, nice for homeowners in the south who get to hang on to their belief that small houses on the outskirts of drab commuter towns are 'worth' £1m. And it's nice for those who think the job of the state is to rig the market. But it is bad for first-time buyers, bad for those who have taken out huge loans to buy something at the wrong price, and bad for capitalism.

House prices should still be lower than they are, relative to incomes, and one day they will be. They can get to the 'right' price in three ways:

1. Real incomes can shoot up unlikely.

2. Prices could fall fast when interest rates normalise. James Ferguson of The MacroStrategy Partnership is fond of pointing out that, in the past, the base rate has normally been around two points over inflation and that mortgage rates tend to be two over that. So if rates were vaguely normal today, they'd be 7%.

3. Alternatively, nominal prices can stay steady, with temporary boosts from more silly schemes, and real prices can fall by about3% a year until the job is done. This is roughly what is happening now.

But don't rule out the second. There are always reasons to be in property: to have a permanent home, to create long-term yield, to hedge against inflation. But, in the end, UK house prices will normalise. Something to bear in mind if you are buying houses in the expectation of making real long-term gains.

Finally a word on gold, a subject on which others have been holding forth at length recently. I will note only comments of one Lorenzo Bini Smaghi, formerly of the European Central Bank's executive board, who said on Thursday that the world's central bankers are "flying blind" with monetary policy. If I didn't have some gold watching my portfolio's back, this is the kind of comment that would scare me witless.

This article was first published in the Financial Times.