We really need to sort out the housing market before it destroys our economy

High levels of debt can cripple an economy. And our cycle of property boom and bust means the most dangerous form of debt is the mortgage. John Stepek explains why.


The best answer is to restrict the flow of credit into the housing market
(Image credit: 2014 Getty Images)

Every big financial bust there's ever been has been preceded by one common factor a big boom.

Economics in general seems to struggle with this. The boom times are seen as "normal" and the busts are seen as aberrations. This is partly because economists are terrible at understanding debt.

But it looks as though they might be starting to wrap their heads around it.

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And the worst type of debt of all? Our old friend, the mortgage...

Guess what more debt makes your economy more risky

The International Monetary Fund (IMF) has looked at how the growth of household debt (predominantly mortgage loans) affects an economy. It's quite a pertinent theme right now. In 2008, median household debt among advanced economies was 52% of GDP; now it's 63%.

Turns out, this probably isn't a good thing.

In the short run, says Nico Valckx on the IMF blog, "an increase in the ratio of household debt is likely to boost economic growth and employment".

However, in the longer run (and not that long three to five years later), "those effects are reversed". Economic growth ends up being lower than it otherwise would have been. It also "substantially increases the risk of a banking crisis".

In other words, debt simply borrows growth from the future and in the meantime, makes your financial system more vulnerable to catastrophic disruption.

The more indebted your economy is, and the faster that debt grows, the slower future growth will be, and the greater the odds of a financial crisis.

Anyone who works in or anywhere near finance should already understand this, of course. Adding leverage (borrowed money) to anything an investment, a business makes it riskier. Why would it be any different for the wider economy?

But economists do have a blind spot where debt is concerned (partly because they argue that every debt is someone else's asset and so it all cancels out somehow).

Anyway, it also turns out that the most destabilising form of household debt is mortgage debt. The irritating thing is that every time someone makes the argument about debt being a problem, some smart alec will come along and say: "Oh, but what about the other side of the balance sheet?" When mortgage debt goes up, "hey, it's OK, because the value of houses is going up too" as if the two things aren't directly correlated.

Then, when the crash comes along the value of houses collapses, but the value of the debt stays the same. And all of these twits scurry back to their spreadsheets and start making noises about bailing out the banks and consumer irrationality and deviations from trend growth, rather than acknowledge that they were simply wrong.

The basic problem is this mortgage lending is pro-cyclical. That means that when house prices go up, lenders become even more eager to lend against them, with ever fewer precautions in place. Just think about it: when do you get 125% mortgages top or bottom of the market? That's right the top.

So you have a kind of financial doomsday machine. The more precarious the debt pile becomes, the more aggressively extra debt is added on top of the existing debt. No wonder it always ends in disaster.

Even before the crash comes, it's unhealthy for the wider economy. As Martin Sandbu points out on his FT blog, evidence from the Bank for International Settlements suggests that "financial growth pushes resources into activities that produce assets easily pledged for credit" houses, in other words.

Those industries, in turn, tend to have lower productivity growth (which is at least partly because the construction industry is heavily subsidised and coddled by government, and therefore doesn't have any incentive to boost efficiency and productivity, unlike manufacturing, for example).

How to end the property boom and bust cycle

Increasingly, I think the best answer is to restrict the flow of credit into the housing market. The Bank of England (and other central banks) can't realistically set the base interest rate purely with an eye on the housing market. So you'd have to make it specific to property.

The Bank is already trying to do this with various "macroprudential" approaches on tightening up mortgage lending, but there might be other structural things you could do.

One idea would be to make mortgages in the UK non-recourse loans, as they are in many parts of the States. In this case, if you can't pay your mortgage, and your house is repossessed, then the bank gets whatever it can raise from selling the house. If that's not enough to repay the debt it gave you, then tough. It can't chase you for the rest.

That would increase the level of risk taken on by the lender, and also introduce an element of counter-cyclicality. How happy would you be to lend someone 125% of a property's value if doing so put you, rather than them, into negative equity right away? You might think twice about it certainly if house prices were at record levels.

Also, we need to strip away all the house-builder subsidies, starting with Help-to-Buy. Make the sector work harder for its profits. At the moment, being a successful housebuilder is about market timing. You make sure you don't buy too much land near the top, and you make sure that you're not a forced seller near the bottom. That's how you make money and that's what separates the industry survivors from the constant casualties.

But if you can start to make the property market less about riding a wave of credit and government subsidies, and more about building better houses, more efficiently than your competitors, then we might see better productivity, and not all have to live in rabbit hutches and feel grateful for it.

There are plenty of other ideas for sorting out the dysfunctionality of the system (my colleague Merryn has a good one on inheritance tax that we'll share with you later this week, and the land value tax is another one that always comes up), and I think it's time we gave them serious consideration, before the next bust comes along. We'd love to hear your views in the comments below.

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.