Storm, The (4 page)

Dr Vincent Cable
( Twickenham) : Is not the brutal truth that with investment, exports and manufacturing output stagnating or falling, the
growth of the British economy is sustained by consumer spending pinned against record levels of personal debt, which is secured,
if at all, against house prices that the Bank of England describes as well above equilibrium level?

Mr Brown
: The Hon. Gentleman has been writing articles in the newspapers, as reflected in his contribution, that spread alarm, without
substance, about the state of the British economy…

A more heavyweight intervention than mine was the warning of the Governor of the Bank of England, who was especially concerned
about escalating housing prices. Although prices continued to increase for three more years, he failed, unaccountably, to
return to the subject. He was presumably persuaded that house prices (as opposed to inflation in goods and services) were
not his primary concern, or that the problem, if it existed, was manageable.

Those who were comfortable with the boom in house prices and debt argued that high levels of debt acquired through mortgages
didn’t really matter, because, unlike in the crash of the early 1990s, there were low interest rates and low unemployment.
But there are some simple fallacies in that argument which are now being uncovered in the reality of burgeoning orders for
house repossessions and growing numbers of households in arrears.

First, bank lending rates were indeed at a relatively low 7.5 per cent even at their peak in July 2007, as against 15 per
cent at the end of the boom in the late 1980s. But inflation was much lower too (2.5 per cent versus 10 per cent), so the
real cost of borrowing was much the same.

Second, the massive increase in house prices – and the willingness of the banks to lend – meant that the absolute size of
mortgage debt, and therefore debt servicing, grew substantially. The average size of a mortgage increased from £40,000 in
1999 to around £160,000 before the market crashed. The cost of servicing the debt therefore became even more onerous than
in the earlier periods of financial stress, despite lower interest rates. Debt servicing as a share of household income reached
20 per cent a year ago, higher than in the earlier peak year of 1991.

Third, even before unemployment rose alarmingly at the end of 2008, unemployment was not the only cause of breakdown in families’
ability to service debt – so were illness, pregnancy, short-time working, small variations in incomes, and redundancy due
to the constant churning of the labour market. Nor is there much by way of a safety net. After 1995 benefits no longer covered
mortgage payments for the first nine months out of work, after which time it is usually too late (though the government has
recently relaxed the conditions). Some households have tried to insure against temporary loss of income; but only one fifth
have done so, and the policies have been so expensive and so hedged around with exclusions that the competition authorities
have been moved to investigate the sharp practices involved.

The leverage of mortgage debt adds two new potent ingredients to the cocktail of problems created by a collapsing housing
market. One is negative equity. If prices were to fall by 30 per cent from the peak, an estimated 3–3.5 million households
would be at risk of having housing debts greater than the value of their property. That position has been reached in some
English towns and cities, although the average price fall, a year after the onset of the crisis, was around 20 per cent (with
much larger falls in commercial property). But in London – or at least the more affluent parts of it – there was little sign
of the major problems being experienced in the provinces. While negative equity is not a disaster for those people happy to
stay put, it necessarily reduces families’ wealth and their willingness to borrow further and spend. The other consequence
of unsustainable debt service is mortgage arrears leading to repossession. It has been cheerfully assumed that there could
not be a repetition of the early 1990s, when 300,000 people lost their homes in the space of five years. We are, however,
unfortunately now heading in that direction, if not beyond it. Annual repossession rates are estimated at 45,000 in 2008,
up from 27,000 in 2007, but were expected to rise further in 2009. A variety of mortgage support schemes and forbearance arrangements
are currently holding back a surge of repossessions, but if unemployment continues to rise and there is a return to more normal
levels of interest rates, the dam will burst.

The growth of second-charge mortgages on personal loans and the securitization of mortgages have meant that there has been
a weakening in banking based upon personal relationships with bank managers; a default in payments now often automatically
triggers a court reference, the first step on the road to repossession. For most, repossession means the loss of a home, and
creates more pressure on the dwindling stock of social housing. There the new homeless are competing with the 80,000 already
in temporary accommodation and the 1.7 million homeless (in England alone) on council lists waiting for social housing, usually
because of overcrowding or unsatisfactory conditions in the private rented sector.

When housing bubbles have burst before, prices have fallen, restoring affordability and a new balance. This time things are
not so straightforward. The bursting of the housing bubble coincides with, and is partially attributable to, the credit crunch:
the unwillingness of banks to lend. Because the market in mortgage securities has collapsed, banks are no longer able to raise
money, other than through new deposits, so their ability to make new loans has been sharply, brutally cut. As banks have adjusted
– not before time – to more realistic levels of risk, they are demanding bigger deposits, of as much as 25 per cent of the
value of a home, and often will not lend at all. First-time buyers, at the time of writing, were having to raise 100 per cent
of their annual take-home pay in order to cover the up-front costs of buying a house. We have a perverse situation where prices
have been falling but affordability has also been declining. Not surprisingly, demand has evaporated, driving the market down
even further.

Thus what has happened is not a correction in the housing market, with a welcome fall in prices caused by increases in supply
relative to demand. Instead, prices have fallen because of the cost of and non-availability of credit. And supply has also
fallen because of a collapse in the building industry. In the latter part of 2009 planning applications were running at a
lower level than at any time since 1948 and home constructions at the lowest level since the 1920s. There is now a great danger
that, if credit were once again to become easily available, there would then be a (temporary) reinflation of the bubble, creating
the potential for
another crash. With endless repetition of ‘good news’ about rising house prices, that prospect is becoming all too real.

The problems of a deflating housing bubble did not end with householders in arrears or in negative equity. The bottom fell
out of the market for new housing. New housing developments, for sale or for buy-to-let, have been coming to completion for
which there are no buyers or tenants. Many buy-to-let landlords have fallen into arrears. And, behind them, developers have
been left with unsaleable stock. There has been a dramatic impact on the house-building industry, with a decline in the number
of houses built from 170,000 down to an estimated 100,000 in 2008, with the loss of 100,000 construction jobs, including specialist
craft and professional skills which will be difficult to reassemble. House builders have seen their share prices fall dramatically
and some have gone under. And because Britain’s planning system links new social housing to new private housing, the supply
of social housing has been dragged down too.

Then the emergence of bad debt among home buyers in a falling market has had knock-on effects on the banks that have lent
the money. Banks with a large mortgage portfolio, like Northern Rock, Bradford & Bingley and Alliance & Leicester, had to
acknowledge the risk of large and growing losses on their mortgage books, added to the losses from other market activities.
Banks responded in time-honoured fashion: by cracking down hard on those to whom they had been only too keen to lend in happier
times. Then, in September 2008, the generalized collapse of confidence in banks led to the virtual disappearance of the traditional
specialist mortgage lenders. The share price of Bradford & Bingley collapsed and the bank was promptly nationalized in order
to prevent a Northern Rock-style saga. Halifax–Bank of Scotland (HBOS) was absorbed by Lloyds in order to prevent its collapsing
in turn, before both had to be saved and recapitalized by the government, as was the Royal Bank of Scotland / NatWest. By
this stage we were
no longer dealing with a British housing and banking problem but with a global financial crisis, and I return to that bigger
story in the next chapter.

The combined effect of the credit crunch, the deteriorating housing market, and the squeeze on living standards from the earlier
hike in energy and food prices created the conditions for a recession. At the end of 2008 recession psychology was taking
over rapidly. Consumers had become very anxious. They were reluctant to spend. Retail sales were falling sharply. And this
in turn led to a slowdown in production, workers were being laid off, more people were unable to sustain mortgage and other
debt payments, and pessimism was deepening in a vicious circle. At some point producers or consumers or both will recover
their nerve and start to spend and invest, but that generalized confidence had not returned by the autumn of 2009, although
the sense of crisis and panic had passed. One of the central premises of post-war Keynesian economics has been that government
policy measures should be used to stimulate demand during a recession. And the shared understanding from previous financial
crises, notably that of the 1930s, has been that such intervention has to be decisive and rapid. These insights have informed
policy in the UK, and elsewhere, throughout this crisis and have undoubtedly had an impact.

The obvious first step was to cut interest rates. It is common ground among both monetarists and Keynesians that this is the
first and quickest way to stimulate demand. One problem has been that the government has transferred the power to set interest
rates to the Bank of England, which has an explicit mandate to use interest rates to curb consumer price inflation, which
at the height of the crisis was running well above the official target level of 2 per cent. The Bank of England was initially
torn between its commitment to combat inflation and a wish to stimulate the economy with interest rate cuts. There was no
easy answer to this dilemma. Faced with precisely the same problem, the eurozone
authorities initially opted to raise rates and the USA to cut them, because they assessed the balance of risks in different
ways. But by October 2008 it had become clear that the British banking system was caught up in a global financial crisis of
massive and dangerous proportions. One of the few remedies open to the authorities in order to prevent a slump was a big cut
in the interest rate. For those of us who believed in the principle of operational independence for the Bank of England there
was a dilemma: to defer to the Bank, which seemed to be moving too slowly, or to call publicly for a deep cut, recognizing
exceptional circumstances. I called for a rate cut of 2 per cent. The Bank of England got there in stages, helped by a concerted
0.5 per cent cut agreed between central banks in October 2008, followed by a unilateral cut of 1.5 per cent, to 3 per cent,
in November, and a further cut to 2 per cent in December. These cuts undoubtedly had an impact, but in the short run the normal
transmission mechanism had largely broken down. The credit crunch was restricting the supply of credit, whatever the price.
Monetary authorities in the UK and elsewhere recognized that parallel action was necessary to restore normal bank lending,
involving unorthodox measures to boost the supply of money, as discussed in
chapter 7
.