Too Good to Last?

For many, many months some Americans have been skeptical of high real estate prices, concerned over the perhaps transient nature of the wealth that has been created for ordinary homeowners across the land. They have looked overseas at other Anglo Saxon nations in an attempt to divine their fate - nations that earlier in the decade led the way in what became a worldwide housing boom.

Housing in the United Kingdom, a sort of miniature United States with an outsized budget deficit to accompany an exceedingly large trade deficit, led The States up in price until sometime last year when things began to cool noticeably, but popping sounds were largely absent.

In this story($) from The Economist, they consider the possibility that real estate prices in the U.K., and around the world have reached a permanently high plateau.

The housing market appears to have stabilised at much higher valuations than were previously reckoned possible. A common measure of affordability is the ratio of average house prices to average earnings, since income must ultimately pay for the acquisition of a property financed with a loan. Looked at this way, homes are even more overvalued than they were at the peak of the boom in the late 1980s: the ratio stands at 6.0, compared with 5.2 in the third quarter of 1989. Much the same message emerges from another valuation method, which, rather like the price-to-dividends ratio for equities, measures the relationship of house prices to rents.

Yet such yardsticks are not the final word. When homebuyers work out whether a property is affordable or not, the cost of servicing a new mortgage as a chunk of take-home pay is more salient. On this basis, valuations are also stretched, but homes are still considerably more affordable than they were at the end of the 1980s (see second chart).

The decline in borrowing costs over the past decade goes a long way to explaining why house prices have proven so irrepressible. Most of the fall in interest rates has arisen from the collapse in consumer-price inflation. In itself, that makes no difference to the real cost of servicing a loan over its lifetime. It does affect the timing, though. When inflation is high, the burden is “front-loaded” in the early years of the loan, but then eases as the real value of the debt is swiftly eroded. When inflation is low, the initial payments are more bearable but more of the real debt persists, which shunts a bigger share of the costs into the later years of the loan.

It seems that the collapse in consumer price inflation, to a large extent driven by cheap imports from Asian trading partners with inflexible currencies, has lulled much of the West into believing that perhaps the best of all possible worlds has been achieved - permanently high housing prices and interest rates that will remain benign until the end of time.

For, without interest rates that are still low by historical standards, there surely would be popping sounds heard as one homeowner after another became unable to service their housing debt amid wages that have stagnated in recent years.

But, how long will interest rates stay low?

Monetary policy around the world is tightening to keep inflation at bay. The Bank for International Settlements—the central banks' bank—said on June 26th that the squeeze must continue. The Bank of England is expected to push the base rate back up to 4.75% later this year.

Britain's homebuyers are vulnerable to quite small increases in the cost of mortgages because they have taken on so much debt during the good times. Overall household borrowing has risen from 110% of disposable income in 2000 to 150% at the start of 2005. The burden of repaying so much more debt means that the total servicing charge is high even at low interest rates.

The most frightening words in the financial lexicon are that it's different this time. This refrain, a favourite of boomsters, was much in vogue at the time of the dotcom bubble. It remains just as suspect when applied to a housing market that is unnervingly priced to perfection.

It seems that much of what we have come to depend upon in the global economy is predicated on low interest rates - low interest rates that allow ordinary individuals to take on extraordinary amounts of debt in order to buy large houses and then fill them with cheap imported goods, somehow still making ends meet month after month.

But how long can this continue if interest rates continue to rise?

Isn't this really too good to last, and shouldn't we all have realized this some time ago?