Evanomics

Economic froth

• Evan Davis | Notes on Real Life |
• 6 Mar 07, 09:00 AM

I’m getting a little worried that the UK economy has overheated a bit and is getting frothy. Should I be?

Here are some reasons to be concerned (unrelated incidentally, to the current volatility in financial markets) and then a few thoughts as to why I could persuaded to be more cheerful.

What has worried me most is the behaviour observed in the property market in general, and the buy-to-let market in particular.

I’m currently making a four part series for Radio 4 on housing (The Price of Property, Tuesdays at 9am; listen to the first episode here) and we have found a lot of spontaneous comment about the so-called “buy-to-sit” phenomenon: people buying rental property, but not bothering to rent it out, because they are only interested in making large capital gains on their property.

As it is not possible for house prices to meet that kind of expectation sustainably, (the long term record is for property prices to rise about 3% ahead of inflation), I can only assume many of these investors are going to be disappointed at some stage.

They will then either have to find tenants (pushing down rents) or will sell. Either way, their behaviour might have quite an effect on the property market.

I am equally struck by the comments of a couple of people involved in private equity. They assure me that a lot of mad prices are being paid for companies.

Both these phenomena seem to indicate a that certain exuberance has taken hold. If either is indicative of a more general mood, we probably ought to be worried.

I’m not a particular devotee of the late JK Galbraith, but I have to say his book A Short History of Financial Euphoria is a very enjoyable read, and it seeks out the common features of different episodes of mass financial insanity, and he mentions financial innovation and the quest for leverage (or debt) among them.

It would be worth all buy-to-let investors looking at it right now. For example, I was at the Homebuyer Show last week, in London’s Excel exhibition centre. There, I saw billboards proclaiming that houses double in value every six to seven years, offer 45% returns and are a safe investment. If these look too good to be true, it is because they are.

Incidentally, a small warning of how things can unravel is emanating from the US in problems being felt by what is called the sub-prime mortgage market, (these are mortgages lent to riskier borrowers, and represent about a fifth of the market) where lenders are reporting disturbingly high levels of bad debts.

However, here are some reasons to be cheerful.

I’m willing to be persuaded that whatever the specifics of buy-to-let or private equity, the UK economy generally may not be too frothy at all.

After all, there can be small bubbles in a calm pond. And in the economy generally, things look less worrying. We saw that after the dotcom spectacle when the UK economy pulled out despite a huge equity crash.

Also encouraging is the fact that Britain’s debt boom seems to have peaked – at least the consumer credit side has slowed down; and so far, the banks are making large enough profits to be able to write-off a big chunk of bad debts without falling into crisis themselves.

Unemployment is not rising and even if it begins to, there will probably be some reverse migration to dampen the impact here (as some central Europeans will inevitably choose to return home if getting a job in the UK proves tough).

Inflation is not as high we had feared it might be a few weeks ago, so if the economy dives, there is room for the Bank of England to cut rates and stimulate the economy, an option that was not available in the late 80s, when we had a recession, but were also trying to beat down inflation.

So, I’m currently not sure where I stand. I wrote a couple of weeks back, that there’s a lot of happy talk among economic forecasters.

Maybe they’re on to something – or maybe they’re on something...

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