Rational and confused about housing

The hype of the housing market has proved just that. Such recovery as was evident in the spring seems to have evaporated.

According to the Royal Institution of Chartered Surveyors today, nearly 60 per cent of estate agents reported a fall in inquiries and viewings in the three months to 30 September compared with the previous quarter. While prices were reported to be stable by three-quarters of the agents, 'optimism about the short-term prospects for the housing market has seeped away as the anticipated autumn pick-up in most areas simply failed to happen', the RICS said.

This non-recovery of house prices is in sharp contrast to the performance of the economy, with growth during the period running above trend at close to 4 per cent a year and unemployment still heading steadily downwards. So the economy is fine, but housing remains depressed. What next?

There are at least two messages embedded here, one for the market itself and the other for the pattern of savings in Britain. Housing first. Back in April this year James Barty and Steven Bell, at Morgan Grenfell, put out a paper arguing that the house price recovery would be weak and that the optimists suggesting a return to boom conditions would be disappointed. The reasons would be the threat of rising interest rates and the squeeze on incomes from higher taxation.

This view, perhaps a little unpopular at the time, has been very much justified by subsequent events - indeed, the market has if anything been even more flat than the Morgan Grenfell team expected. Looking back over the past six months, James Barty reckons that the fact that the market failed to recover has itself added a further reason for expecting the market to continue to be stagnant.

Because there was no rebound in prices as the economy took off, there is no pressure this time on potential buyers to try to get in at the bottom.

Unlike in previous cycles, there will clearly be many more chances of buying houses cheaply in the months ahead.

This raises the big question - what is now the 'normal' level for the housing market? Houses are now at their most affordable in the sense that they are at 3.5 times average earnings, the bottom of the range since 1970.

Normal since 1970 would be 4 to 4.5 times average earnings. But maybe, in a world of very low inflation and rather high job insecurity, the new normality will be prices of 2.5 to 3 times average earnings or less?

If one has to head into unmapped territory it would be comforting were it possible to look back in history to previous periods of low inflation and see what the ratio was then, or to look to other countries for guidance.

Alas, it is very hard to see any decent parallels, for in Victorian times only a small minority of middle-class people owned their own homes.

In Germany today less than half the housing stock is owner-occupied, so this gives little guide. In the US housing is very regionalised so that income-house price ratios mean little, though in general houses seem to be cheaper relative to income than here.

We do, however, know that when an unexpected house price shock strikes a market that is largely owner-occupied it may take many years for the market to recover. In the Netherlands the early 1980s recession caused house prices to fall sharply in nominal terms. It took the best part of 10 years before any real buoyancy returned.

If people have yet to come to terms with a long period of flat house prices, they have hardly begun to think about the message for the pattern of savings. But one can sketch what ought to happen, given that human beings are rational economic animals. They ought to save by investing in other financial assets.

The pressure to acquire other assets comes from two sources. First, anyone owning a house will have seen their equity either go negative or decline over the past four years. Savings are therefore needed to offset that. (Just as rising house prices encouraged people to run down savings by withdrawing equity, so a fall in equity should encourage savings.) And second, since houses are self-evidently an uncertain investment, it makes prudential sense to balance that with other assets with different characteristics.

The rational investment to supplant the home as the 'least risky' investment would perhaps be index-linked gilts. Once people have bought their main home their next investment ought really to be indexed gilts. After that they could start building up holdings of bonds and equities.

But, quite aside from the fact that people will have to become accustomed to under-housing themselves, which they may not like, we do not yet have much feel for the way in which people will respond to such different economic signals. We may be rational, but we are also confused.