Home fires still a long way from flaring up

The failure of the housing market to stage a convincing recovery was one of the many surprises of last year. The year started well, with housing transactions up by more than 30 per cent on 1993 and prices rising. However, as the year progressed, recoverystalled. Both transactions and house prices could have ended 1994 lower than December 1993. Why did this happen?

One of the more popular explanations is that the withdrawal of attractive fixed-rate mortgages from the spring onwards contributed to the downturn in the housing market, depressing prices. Certainly, this could be a contributory factor. The consumer is not just risk-averse, but debt-averse and extremely price-conscious. Caution towards debt on the part of the consumer is entirely rational, given the way that the recession was the direct result of the borrowing binge of the 1980s. Higher int erest rates are hardly helping this debt-aversion abate.

The withdrawal of attractive fixed-rate mortgages is, however, probably not the main cause of the housing market's current plight. The one factor that, above all, drives house prices is personal disposable income. The purchase of a house is typically thelargest single transaction that anyone will make in their lifetime. It is hardly surprising then that the prices of owner-occupied houses are already related to the incomes of the owners. Every boom in house prices has been preceded by a significant acceleration in personal disposable incomes. Every bust in house prices has occurred after house prices have become grossly inflated relative to incomes.

Higher mortgage rates, as in 1973 and again in 1989, can provide the catalyst for a substantial correction in the housing market. However, the principle cause of every downturn in the housing market has been a vastly overstretched ratio of house prices to earnings. Higher mortgage rates in 1985 did not stop that housing market recovery in its tracks. House prices were not out of line with earnings then and personal disposable incomes were growing strongly. House prices only became overstretched relativeto incomes in the late 1980s.

The chart shows the ratio of house prices to personal disposable incomes per head since 1946. There have been three distinct booms in the housing market on this measure - 1948, when house prices peaked at 10.6 times personal disposable income per head, 1973, when house prices peaked at 9.7 times personal income and 1989, when house prices peaked at 10.2 times income. These compare with an average of 7.6 times personal disposable income per head over the entire period.

In the long term, house prices tend to grow more or less in line with personal incomes. However, this disguises the volatility of house prices and the fact that house prices can fall as well as rise. Sharp corrections in house prices quickly followed thebooms of the 1940s, 1970s and 1980s. In nominal terms, house prices fell in 1949, 1952, 1953 and 1954, as well as in the recent recession. In real terms, they fell sharply after all three booms.

A large part of the housing market's recent problem has been the extremely weak growth in personal disposable incomes. On the figures to date, personal disposable incomes may have grown by less than 4 per cent on average in 1994. On the face of it, this sounds like respectable growth. However, this would be the weakest outturn since the 1930s depression, when house prices collapsed, and contrasts with the 1970s, when personal incomes grew at an average of almost 16 per cent, and the 1980s, when the average growth was around 10 per cent.

Personal disposable incomes were hit by the tax increases in the Budgets of Norman Lamont and Kenneth Clarke in 1993. It may be no coincidence that the housing market recovery stalled after the tax brake was applied last April. Personal disposable incomes fell very slightly in the second quarter of 1994, a highly unusual occurrence.

More important still is a low-inflation environment, which means low wage growth. On that score, there are currently far closer parallels with the 1950s than the 1970s and 1980s.

The 1950s hardly give one great optimism about the near-term outlook for the housing market. House prices rose by an average of only 2 per cent a year between 1955 and 1959, following the downturn that occurred in the early part of that decade. Of course, there are many differences from the 1950s, including the financial deregulation and the move to greater owner-occupation that occurred during the 1980s. However, the 1950s do at least illustrate the difficulty in achieving a strong recovery in house pr ices in a low-inflation environment.

High inflation helped to enable the 1970s housing market downturn to be relatively short-lived. In nominal terms, house prices did not fall at all in the mid-1970s. There was a mini-boom in house prices between 1978 and 1980, only a few years after the mid-1970s downturn.

That, however, is a very different environment from the one we currently face. A low-inflation environment is increasing the time taken for the excesses of the 1980s to wash through the system. The withdrawal of attractive fixed-rate mortgages and the problems of negative net equity would not have proven such headwinds for the housing market if personal disposable incomes were growing strongly, rather than growing at their slowest rate since the 1930s. Certainly, a little bit of wage inflation is no badthing for the housing market.

House prices tend to be more volatile than retail prices. Housing demand tends to be heavily influenced by attitude to debt and inflation psychology. There is evidence to suggest that in a low-inflation environment house prices can fall for an extended period in real terms. House prices fell for 10 consecutive years in real terms up to 1958. In contrast, in the high-inflation environment of the 1970s, house prices fell for only four years between 1974 and 1977, after the housing market boom of the early1970s.

Moreover, demographic trends are no longer so favourable. The number of households may slowly be rising - potentially boosting housing demand - but the number of 25 to 29-year-olds is in the process of falling sharply. This removes an important prop to the housing market, given that many first-time buyers come from this segment of the population.

The number of 25 to 29-year-olds could have fallen by around 2.5 per cent between 1992 and 1994 and official projections show a further fall of 3.5 per cent between 1994 and 1996. This is in contrast to the 1980s, when the number of 25 to 29-year-olds rose strongly, being up by almost 25 per cent over the decade.

The reduction in mortgage interest tax relief does not help matters either. Mortgage interest tax relief was restricted to 20 per cent last April and will be restricted to only 15 per cent this April. The peak of mortgage interest relief coincided with the housing market boom of the late 1980s. At its peak, mortgage interest tax relief amounted to more than £8.5bn at today's prices. This is set to fall to less than £3bn by fiscal 1995/96.

No one doubts that house prices will rise over the course of this economic cycle. The relationship between house prices and earnings is no longer stretched. In fact, on most measures, housing looks relatively cheap. Moreover, although further restrictions to personal tax allowances take effect this April, personal disposable incomes should accelerate decisively later in 1995.

However, the legacy of the 1980s still looms large. Job insecurity has been a key factor holding back the feel-good factor and has undoubtedly held back the housing market. More importantly, in a low-inflation environment it is difficult to envisage personal disposable income growth being as strong as in the 1970s and 1980s, even if the Government announces sweeping tax cuts this November. A low-inflation environment in effect rules out another housing market boom for the foreseeable future.

In one sense this may be considered a good thing, reducing the risk of boom/bust in the wider economy. However, it is unlikely to help the Government's re-election chances.

David Owen is UK economist at Kleinwort Benson Securities.