The coming house price crash in Europe

By: Wolfgang Münchau

There are several routes that get us from a credit squeeze to a recession. Last week I wrote about a falling dollar as a transmission mechanism. The property market is another one, at least for some European countries.

Over the past decade, we observed large housing booms in the US, where property prices almost doubled between 1996 and 2006 in real terms. Price increases were particularly strong in coastal regions. We have also seen extreme movements in the UK, Spain, Ireland and in central Europe.

 

In a perfect market, where supply of housing quickly adjusts to demand, one would expect the real value of property prices to be broadly stable over long periods. As we all know, property prices can and do rise, even in real terms. We have heard a lot about supply constraints, for example building restrictions. But this can only explain different price levels, not different growth rates. What about excess demand? All those investment bankers drive up property prices in London, for sure, but again you need more than excess demand in one region to produce a nationwide 10-year boom. You need excess demand to increase at accelerating levels each year, and not just in one region. What about home improvements? Again, these can hardly explain why prices keep on increasing long after we have installed the air-conditioning system. None of these sound plausible to me as explanations for the extreme house price increases we have observed. To achieve that effect, you need credit – a lot of it.

In Spain, if you are poor and have no credit rating, it is easier for you to obtain a mortgage than to rent an apartment. In the UK, which has also seen extreme house price increases over the past decade, building societies used to hand out mortgages of up to 130 per cent of the property’s value, at up to five times an applicant’s income. The mathematics behind these mortgages is based on what economists call a Ponzi game – a gambit that will eventually collapse.

There is fortunately no need for new regulations to crack down on such irresponsible lending practices. The market has done it for us. The credit bubble is over, thanks partly to a buyers’ strike for asset-backed commercial paper. Back in the 1990s, UK mortgages were offered at a maximum of 95 per cent of a property’s value and a maximum of three times income (less for married couples). These were much more sensible lending practices. As we return to a more normal credit market, there will simply be less money to finance a boom, as house prices adjust to the availability of credit.

It takes time for house prices to fall, but when the process starts, it can quickly build its own momentum. The Case-Shiller house price index for the US peaked in the second quarter of 2006. In the second half of 2006 prices fell at moderates rates, but this year the decline in prices accelerated. I have no doubt that the various European property markets will follow a similar path, with the usual time delay. By this time next year, I would expect to see house price declines in the UK, in Spain and Ireland.

Since the economy in all these countries is heavily dependent on the property market, a house price recession is obviously bad news. Of course, very aggressive interest rate cuts would help reduce the impact, especially in countries with variable-rate mortgages such as the UK or Spain, or where mortgages can be easily refinanced, such as in the US. But unlike in 2001, there is much less scope for interest rate cuts this time round, including in the US. Even if central banks do the maximum in their power to help the property market, they will probably not suddenly give up any pretence of pursuing price stability at a time when oil and commodity prices are reaching new records. Inflationary expectations are building up everywhere in the world. A good global indicator of inflationary expectations is the price of gold, which has just reached a 27-year high and where market sentiment remains bullish. The odds of a 1970s-style hard landing have shortened considerably.

The Italian economist Tommaso Monacelli has produced some interesting statistics* showing the correlation between house prices and private consumption in various countries. They are highest in the UK, followed by Spain, Denmark, the US and Canada. These are all economies that have experienced high economic growth rates in recent years, in contrast to countries such as Germany where house prices were flat.

This raises the question of whether, and to what extent, the superior economic performance of these countries was due to the credit boom. My own hunch is that we will soon have to change our narrative of economic growth, and accord a much greater weight to the importance of money and credit.

Send your comments to munchau(at)eurointelligence.com

Copyright The Financial Times Limited 2007

---