Stephen King: Loosening housing's hold can only be better for the economy

Should Britain move towards long-term, fixed-rate, mortgages? The Chancellor certainly seems to think this would be a good idea, whether or not we eventually decide to join the euro. One of the obvious problems with euro membership is that British householders love to borrow at variable interest rates, linked to base rates, whereas Continental European homeowners prefer to borrow at rates fixed over, say, 20 or 30 years. So, with Britain in the euro, changes in European Central Bank interest rates would have a disproportionate impact on the UK compared with other eurozone countries.

Even outside the euro, there could be a case for more use of long-term, fixed-rate mortgages. Gordon Brown clearly believes that the link between Bank of England monetary policy and the housing market is too close; when the Bank of England changes interest rates, the impact tends to be a lot greater on the housing market than on other parts of the economy. The danger with this process is obvious - the UK housing market could go whizzing off too far in one direction or the other, leaving the rest of the economy far behind and, as a result, create a "two-tier" economy that might not be sustainable over the medium term.

The Bank of England, however, clearly has doubts about this conclusion. In evidence to the Treasury Select Committee last week Charles Bean, the Bank of England's chief economist, argued that a move towards longer-term funding of mortgages could increase the volatility of base rates. "You would certainly have to move rates more than you would otherwise have to do to have the same impact on demand. So in that sense [policy] would be less effective." The Bank's Governor, Sir Edward George, whose last day in office is today, used a different angle; in his view "this is a question of the demand side rather than the supply side". Put another way, why have fixed-rate mortgages been forced down the throats of an unwilling public?

In the light of recent experience, the Bank's arguments look quite robust. Over the past two years, the UK has outperformed the eurozone in part because of the proactive approach to interest rates used by the Bank. With industry weak as a result of the global downswing, consumers have, in large part, kept the British economy growing.

Their desire to spend has come primarily from the housing market and the extent to which the Bank has been able to manipulate variable mortgage rates. In another world, where mortgages were all funded at the long end, the Bank would have found it a lot more difficult to come up with the same result. After all, long rates are a lot more dependent on global interest-rate trends and are therefore much more difficult for the central bank to control. In a fixed-rate world, the Bank would have been hard pushed to stabilise the economy; unemployment would have been higher, inflation low and the Government would presumably be running a much bigger budget deficit.

I think these arguments are about right, given the Bank's inflation-targeting mandate. I'm less sure, however, that these arguments ensure that the economy as a whole is better off with mortgages funded mostly through variable rates. Certainly, current arrangements provide the Bank of England with a powerful weapon of monetary policy. However, it is a lot less obvious that the implications of using this weapon are universally good.

The issue is one of imbalances. Sharp reductions in mortgage rates may allow the economy to expand more quickly, but there is a cost in the form of potentially unwelcome changes in the value of assets and liabilities. The great British public sees housing not just as a utility, something that provides a stream of accommodation services, but also as an asset, something that allows them to feel rich or poor, depending on which direction the market is heading. Housing also gives the public better access to capital markets. It is far cheaper to borrow by taking on an additional mortgage than it is to borrow through a personal loan.

In the short term, this arrangement suits the Bank of England down to the ground - the more it can influence expectations within the housing market, the more it can influence aggregate demand through consumer spending. There is, however, a price to pay. Let's say that the Bank needs to cut interest rates by a certain amount to persuade consumers to pick up the baton of growth dropped on the floor by a stagnating industrial economy. Consumers respond favourably by increasing housing purchases and, in time, by indulging in mortgage-equity withdrawal. House prices start to rise, giving consumers the impression that they are getting richer. They spend even more and, in time, they begin to speculate on housing as well.

Meanwhile, industry is not getting any better. Held back by the chill winds of global deflation, companies hang on grimly until the point is reached whereby either they go bust or, alternatively, they have to slash costs. At this point, consumer incomes become increasingly vulnerable. What then happens to the housing market? Despite low levels of interest rates, it is unlikely that consumers under these conditions will want to take on more and more debt; they become increasingly cautious, the housing market begins to subside and all that extra consumer spending financed through credit begins to go into reverse.

The critical feature of this story is the difference between assets and liabilities. Assets that are based on some form of real economic worth - housing and equities, but not cash or government bonds - carry a certain value because they are supported by expectations about future incomes or future profits. When those expectations are buoyant, house and equity prices are likely to go up rather quickly, making it easier for leverage to increase which, in turn, creates even more upward pressure on asset prices. When, however, those expectations begin to subside, the credit cycle is in danger of heading off in the opposite direction; the assets may have fallen in value but liabilities will not have done. At this point, people start to worry that they have too much debt given their downwardly revised expectations about future income.

So boosting the housing market through changes in interest rates may give people a false sense of security about future income growth. Homeowners do not always know what is going on in industry or in the world economy. All they see is their monthly mortgage bill going down. They have every reason to feel better off. If, however, it turns out that their new-found wealth is no more than an illusion, they will have overspent and undersaved. At this point, the economy will slow down even further, creaking under the weight of excessive debts, and last week's first-quarter GDP release, showing a rise of just 0.1 per cent with consumption up just 0.2 per cent, could be pointing in precisely this direction.

Ultimately, for the economy as a whole to be stable over the medium term, each part of the economy has to understand what is happening in the other parts of the economy. If that understanding is not there, consumers or companies might end up borrowing on an increasingly unhealthy basis. The process might keep the economy going a little bit longer in the short term but, ultimately, the economy might still come unstuck. For decades now, policymakers have taken comfort from the strength of the housing market, often conveniently forgetting that short-term strength often points to more serious troubles later on. The ability to influence the housing market through changes in short-term interest rates is certainly considerable but, ultimately, it's a bit like chopping onions with a chain saw - you might get the job done, but think of the damage to your kitchen.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com