Messrs Carney and Osborne are turning out to be a dangerous double-act for UK residential property investors. They have been using monetary and fiscal policies through a combination of directed bank lending, selectively increasing transaction taxes and by implementing other tax policies with a view to suppressing demand for residential property.
If they think they can fine-tune these markets, history suggests they will eventually fail. There are significant challenges facing the UK residential property investors already, without state intervention. Incidentally, the problems discussed herein have little to do with the current difficulties faced by commercial property funds in the UK, which have had to suspend redemptions because of illiquidity, though their structural failure sends us a timely reminder about this inflexible characteristic of property generally.
Residential property has become everyone’s pension fund
Over the years, private individuals in the UK have learned that buying residential property is the best way to protect capital. Rising property prices have been the natural consequence of official efforts to reduce the purchasing power of sterling over time, and consequently property is widely accepted as a better long-term investment than other savings vehicles, such as bank deposits, listed securities and mutual funds. The desire for something tangible and better, the safety of bricks and mortar, has inevitably led to a substantial increase in buy-to-let investment, with many private individuals buying one, two or even three rental properties with the aid of mortgage finance. This has greatly increased the rental market’s supply, which is economically beneficial at a time of high net immigration and increasing job mobility.
This is not how George Osborne’s advisors at the Treasury appear to see it. To them, the restriction of overall housing supply, undoubtedly due to inflexible planning regulations, is the main reason for rising prices. As always, the problem is seen by government economists as leading to an undesirable redistribution of wealth in favour of existing, already wealthy home-owners, disadvantaging the future generation, struggling to get on the property ladder. The policy response has been to impose higher taxes, first on residential property owned by foreigners, and then on the buy-to-let market. Buy-to-lets will also suffer the marginal effects of the introduction of discriminatory capital gains taxes, and the removal of normal business tax reliefs, particularly as regards borrowing costs.
The government’s approach is founded on the same underlying premise behind all price controls: the market has failed and the state can improve on the market. Government has a self-imposed duty to ensure prices remain affordable for first-time buyers, and the suppression of capital values also serves as an indirect means of rent control.
However, the use of fiscal policies to control prices is doomed to fail if the lessons of history, let alone sound economic theory, are any guide. Meanwhile, the Bank of England has been busy telling banks on what terms they can offer mortgages, and to whom. But Instead of managing the market for a desired outcome, monetary and fiscal policies are unlikely to affect prices significantly, so long as interest rates remain suppressed at close to zero levels.
The underlying point is that by their actions both Mark Carney and George Osborne are behaving as if they are wholly ignorant of the real reason property prices are rising. It is the Bank’s interest rate policy and the intended, if gradual, destruction of the currency that’s the underlying cause, leading to investment flows into everything that’s not deposit money. They have corralled reasonable people into a confined investment space, and do not appear to understand the long-run consequences of their actions. Furthermore, they particularly fail to grasp the important message from the market, which is that long-term investments, such as residential property, art, equities, and now even gold, are effectively discounting an accelerating rate of loss of purchasing power for deposit money.
In addition to Carney’s and Osborne’s attempts to manage the market, the new Basel 3 banking standards will impose a greater haircut on mortgage lending by the banks from 2019 onwards, and undoubtedly banks will be reducing their supply of mortgage finance well in advance of that date. This macro-economic change, no doubt for prudent reasons, will have a negative impact on funding for property purchases, in the longer term.
Interest rates will eventually rise
That is the background to what will inevitably become a future crisis, when interest rates eventually rise. There are early signs this could happen sooner than most analysts expect. Official rates of inflation are set to increase in the coming months as higher energy and commodity prices begin to bite, an effect worsened by the fall in sterling. Doubtless, it is concerns over future interest rates that have had some influence on investors in commercial property funds.
At the same time as anxieties over long-term sterling interest rates grow, an increasing awareness of short-term systemic risks in Europe are encouraging the financially-aware to reduce their cash deposits in the banking system. The price-effect of economic actors swapping money for other financial assets, and eventually goods as well, promises to lead to an accelerating decline in purchasing power for all currencies, initially in terms of investable assets and ultimately for physical goods as well. The current, surprising strength of various asset markets is just that: an early anticipation of an accelerating loss of the future purchasing power of major currencies, and runs counter to the risk that the next move for sterling interest rates should be up.
This market dilemma has been driving markets for some time now, ever since the post-Lehman turbulence settled into continued interest rate suppression, and is the “pump” in this article’s title. For the moment, this pump phase is being extended by a renewed banking crisis, which can be expected to provoke central bank responses of yet more monetary stimulus, not only in Europe, but elsewhere as well, even in post-Brexit UK.
At some stage, concerns are bound to increase over the long-run consequences of a new round of monetary inflation, with the discounting of the effect on prices spreading from assets into goods. So the Bank of England, in common with the other major central banks, will eventually find itself in an impossible position, conflicted between the need to raise interest rates to protect sterling, and avoiding bankrupting the middle classes which have taken on record amounts of mortgage debt. That will be the “dump” in our title.
The effect of rising nominal interest rates will be a nightmare for all asset markets, not just residential property. The effect on residential property can be expected to hit house prices hard, risking widespread distress, initially because of vanishing mortgage finance, accelerated by the Basel 3 regulation changes, and then through actual foreclosures. However, property investors who can sit out this phase of the crisis might wish to bear in mind that property will continue to offer protection against monetary destruction, after over-leveraged home owners and buy-to-let investors have been shaken out.
This is because the fundamental logic of owning a property asset is that it is more productive in its use-value than depreciating money, giving capital protection to a degree perhaps second only to gold.
