JUST as the last five years of monetary policy have boosted the incomes of the top 1% (the remuneration of CEOs, bankers, fund managers etc are all linked to the stockmarket), they have also helped to resurrect an old British problem—an overinflated housing market. It has also given the Bank of England an awkward dilemma.

Unlike in America, British house prices never really fell back to fair value. The ratio of prices to first time buyers' earnings has varied over the past 30 years between 2.1 (in 1995) and 5.4 (in 2007).

As the economy plunged into recession, the ratio dropped to 4.1 in 2009, but fell no further and is now back at 4.7, a level it only exceeded in the middle of last decade. In London, the ratio peaked at 7.2 in 2007 but has streaked past that level in the current cycle and is now at 8. (It is not entirely a London problem; the ratio in the south-west is 5.4.) In part, of course, this is down to low interest rates, which have made mortgages more affordable. Nationwide, a building society, also has an affordability ratio, which compares mortgage payments with take-home pay; that peaked at 51.8% in 2007 and is now down at 32.6%.

The Bank can hardly increase interest rates to deal with the issue since the knock-on effects for the rest of the economy would be so great. So it could use other measures such as capping the loan-to-value ratio, stopping people from taking out 95% mortgages. But that runs counter to the government's policy which has been to enable people to afford homes by making it easier for them to get high loan-to-value mortgages. Without such deals, first-time buyers are shut out of the market.

If prices are too high, then the answer is not to subsidise the purchase of such goods (or assets) but to bring down the price. And the way to do that is to generate more supply. That is especially the case when a country, like Britain, has absorbed a lot of immigration. But whether you blame the private sector or successive governments, the country has failed miserably on that score. Here is a table from an earlier blog showing the mismatch, looking at changes in population and new home creation over various census periods.

Rise in population Homes built

1971-1981 500,000 2,922,850

1981-1991 1,000,000 2,128,960

1991-2001 1,700,000 1,864,380

2001-2011 3,500,000 1,875,350

This supply failure is nothing to do with the Bank—it has to do with planning laws and the retreat of local government from housing provision for the poor. But I think it is symptomatic of a more general problem—the relationship of the financial markets with the rest of the economy.

Here is how the model has worked. An asset price rises and this engenders confidence among consumers (house prices) or businessmen (equities). The price rise gets out of hand. When prices start to fall, central banks worry that confidence will suffer (1987, 1998, 2001 etc) so intervene to cut rates. This props up prices further. The problem is all the greater in property where people have borrowed money against the asset; too big a price fall will trigger negative equity, bad debts, problems for the banks and so on. No-one wants this so the need for central bank intervention is seen as all the greater.

This leads to a situation where asset prices seem to be permanently inflated relative to fundamentals such as profits or incomes. As already pointed out, this boosts the wealth of the rich who own most of the assets. But it also means that houses can only be affordable if credit standards are loose. That in turn means the consequences of returning interest rates to "normal" levels will be all the greater in terms of lost confidence and bad debts.

So we are trapped in a world of low interest rates and high asset prices. One feels the whole plate-spinning exercise must come crashing down at some stage but it is impossible to predict when. As the late Tony Dye said (with reference to the dotcom bubble), "If you know a train is travelling ten stops and is bound to crash before the terminus, when is it rational to get off?"