'The house price crash starts in 2008'

Analysis: Fred Harrison is author of Boom Bust: House Prices, Banking and the Depressioon of 2010. Here he discusses solutions to the boom-bust cycle...

Ten years ago, in my book The Chaos Makers, I forecast what would happen to the economy in 2008: a house-price crash ahead of a wider recession.

My prediction looks like being confirmed: the latest survey of the housing market shows house prices stalling in most parts of the country, with predictions of a fall next year. Meanwhile, the Chartered Institute of Personnel now expects unemployment to rise by 150,000 — taking the number of people out of work to its highest level since 1997.

It need not have unfolded this way. In 1997, I submitted papers to Gordon Brown, the new Chancellor. I explained that house prices would peak in 2007 because of frenzied activity in the land market.

I warned that the downturn in house prices would presage a global depression in 2010 — unless he radically reformed taxes so that they were shifted away from work and towards speculation in land. That way, investment would go into the real economy instead of simply fuelling another property boom. Naturally, Mr Brown took no notice.

Instead, he stuck with conventional Treasury policies. But handing responsibility for setting interest rates to the Bank of England was never going to stop the property market from soaring: lower interest rates might be good for business but they also give landowners and speculators an even bigger return on their land, fuelling a new property boom.

People are now being lulled into thinking Britain will still manage a 'soft landing'. House prices may turn down over the next six months, according to the consensus view, but they will pick up again towards the end of 2008. These assurances are irresponsible.

They encourage first-time buyers to jump into the housing market when they see prices weakening. But in my view, the decline in house prices will exceed 20% over the next two years. The argument in favour of a soft landing is that the 'fundamentals of the economy — the basic strength of markets and major businesses — remain sturdy.

This is exactly what Mr Brown emphasised in his New Year message at the weekend. But it ignores two crucial facts. First, the causal mechanism between house prices and the wider economy actually works in the opposite direction.

A decline in house prices is good news for first-time buyers but it is highly damaging for the economy. We have grown to rely on property as the collateral for our credit-funded consumption binge. Reduce the value of the collateral and people's spending power is reduced, too. That raises unemployment and further weakens people's willingness to buy property.

>> Editor's Blog: Why house prices and shares are predicted to fall in 2008

The historical evidence is clear: over the past 200 years, housing booms have always been followed by recessions. Our economy is like a drug addict: the heroin of house-price rises is bad for the body, but cold turkey is still a painful business.

The other reason Mr Brown's argument is wrong is that we cannot any longer dismiss a house-price crash as just a local factor. The real estate sector is now effectively a single global market; property cycles have converged.

The US cycle came to an end in 2006. The housing markets in Ireland and Spain came to an end in 2007. Downturns in property prices are surfacing all the way from Eastern Europe to the Far East. The remaining property markets will peak in 2008.

As the property dominoes fall across the globe, the ensuing financial crisis will eclipse the present current credit crunch in the banking sector. It takes two years or so for a recession to take hold after house prices have peaked. So I am satisfied that my gloomy prediction of a full-blown recession in 2010 will turn out to be correct.

Can the Government soften the blows? Historically speaking, once a landmarket-led frenzy has taken its toll, there is little governments can do to prevent unemployment. Even so, ministers should now focus on two areas of policy.

First, they should avoid making the downturn even worse. If, for example, the Treasury sticks with its plan to level down the tax rate on capital gains, there will be a sharp drop in prices in the summer. Owners of buy-to-let properties are waiting for the new tax year to offer their apartments for sale, when the CGT rate will be cut from 40% to 18%. The effect will be a crash in prices, denting confidence even further.

Second, ministers should lay plans for an increase in the output of affordable houses over the next property cycle, thus restoring some confidence to the property market. As things stand, I forecast Mr Brown will not achieve his target — three million new homes built by 2020. Housing starts began to fall last year: this always happens when the price of land becomes unaffordable. But if government offered the right incentives, building firms could kickstart their construction programmes and create some new jobs. In the longer term, ministers should give priority to reforming the tax system.

Taxes which penalise people who work, save and invest should be reduced or abolished. Given the bad times ahead, the Chancellor should give priority to reducing income tax (which makes it uneconomic for some people to work) and VAT (which reduces consumption).

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Instead, a tax on land values would let government raise revenue from the value created by investments in public infrastructure, such as the Jubilee line extension. Such investments raise the productivity of the economy — for example, by getting people to their place of work more quickly.

These gains from taxpayers' investments surface as rising land values: a flat in Stratford, for example, will be worth far more when Crossrail opens for business. But as the tax system stands, the public purse gets very little of the benefit back. Shifting taxation so that owners of land paid an annual tax on that land's value — rather than on the property sitting upon it, as council tax does — would also discourage speculation and a new property bubble.

For the enterprise economy, a shift towards such a tax on land values is the most benign way for government to raise revenue. Progressively reforming the tax regime in this way would lift the spirits of the nation. It would give Britain a head start as the global markets recover around 2012. It would place the housing sector at the cutting edge of a new period of sustainable growth.

It will be hard to avoid bad economic news in 2008. Shouldn't that be all the more incentive for political leaders to work together to agree a radical way out of the cycle of boom and bust?

• The new edition of Fred Harrison's Boom Bust: House Prices, Banking and the Depression of 2010 is published by Shepheard-Walwyn.