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Good Inflation, Bad Inflation: The Housing Boom, Economic Growth and the Disaggregation of Inflationary Preferences in the UK and Ireland
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Colin Hay

Professor of Political Analysis Department of Politics, University of Sheffield, Sheffield, S10 2TU, UK

Email: c.hay@sheffield.ac.uk

Paper presented at the annual meeting of the American Political Science Association, Toronto, 3rd 5th September 2009.

Electronic copy available at: http://ssrn.com/abstract=1461509

____________________________________________________________________ Good Inflation, Bad Inflation: The Housing Boom, Economic Growth and the Disaggregation of Inflationary Preferences in the UK and Ireland ___________________________________

Colin Hay, University of Sheffield

Abstract: This paper presents a comparative analysis of the determinants, sustenance and broader macroeconomic consequences of the ultimately unsustainable housing boom in Ireland and the UK in recent years. It examines, in particular, the role played by ostensibly depoliticised monetary policy in both contexts in the development of a house price bubble which served to fuel consumer-led growth. It assesses the viability, sustainability and reproducibility of the private debt-financed consumer boom that house price inflation has generated. In the process it draws attention to the increasingly differentiated character of both government inflationary preferences and counterinflationary performance - with the shift to official measures of inflation that exclude mortgage interest repayments and, in the UK at least, to the covert repoliticisation of monetary policy. It concludes by suggesting that governments may well not have timeinconsistent inflationary preferences, so much as sectorally specific inflationary preferences. This might be summarised in terms of the aphorism retail price inflation poor, house price inflation good. _____________________________________________________________________

The recent implosion of the house price bubble in the advanced liberal economies raises serious concerns about macroeconomic management, the counter-inflationary preferences of public authorities in particular. Those concerns are perhaps most acute in the Anglophone liberal democracies, whose economies experienced both the

An earlier version of this paper, with the crisis still in its inception, was presented at the Warwick I am

conference on The Political Economy of the Subprime Crisis, 18-19 September, 2008.

extremely grateful to participants for their helpful and encouraging comments and suggestions and to Paul Lewis, Ed Page and Matthew Watson for various conversations about the repoliticisation of monetary policy in the UK.

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Electronic copy available at: http://ssrn.com/abstract=1461509

largest house price increases and which have now suffered the most spectacular downward recalibration in prices - and whose growth strategy in recent years seems to have rested most heavily on consumption fuelled by equity release in a rising housing market.

This paper argues for the merits of a comparative approach to the inflation and puncturing of the house price bubble in such economies (see also Hay, Smith and Watson 2006). As it seeks to show, even in ostensibly most similar cases, the determinants of house price inflation and deflation in recent years are multiple, complex and differentiated. Acknowledging this has important implications for an assessment of the sustainability or unsustainability of the growth trajectories of such economies since the early 1990s and the likelihood of a return to sustainable growth in the years ahead.

The basic argument of the paper is simply stated. For rather different reasons, Ireland and the UK stumbled serendipitously upon consumer-led and private debt-financed economic growth trajectories in the early 1990s. In both cases this trajectory was secured and sustained by historically low interest rates. This served to broaden access to - and to improve affordability within - the housing market, driving a developing house price bubble. Once established this was sustained, if not perhaps actively nurtured, by interest rates which remained, by recent historical standards, unprecedently low throughout the boom. Yet, as is now increasingly acknowledged, it was not just low interest rates which served to inflate the bubble. Crucial, too, was the liberal and highly securitised character of the mortgage market in both Ireland and the UK (see, especially, Schwartz 2008; Schwartz and Seabrooke 2008; Watson 2008a). In such a context, banks and building societies came to act effectively as financial intermediaries, repackaging new loans as mortgage-backed securities (MBSs) for institutional investors such as pension funds. The lions share of the associated income was generated, not from the interest rate spread between deposits and loans, but from transactions fees. Consequently, they had a strong incentive to become energetic and innovative in offering new mortgage instruments to potential borrowers, confident in the knowledge that they could pass on any interest rate risk they might otherwise bear to buyers of MBSs. In a rapidly growing housing market, they also became a key source of capital to fuel consumption for borrowers keen to 3

release the equity they had built up in their property. As Herman Schwartz suggests, the disinflation of the 1990s combined with the operation of global capital markets differentially to produce increased aggregate demand in countries characterised by widespread home-ownership, high levels of mortgage debt relative to GDP, early refinancing of those mortgages and mortgage securitisation (2008: 263).

That was then. As is well known, a global crisis of confidence in mortgage backed securities, arising initially from concerns about the quality of sub-prime lending in the US, and inflationary pressures associated with rising fuel and commodity prices brought this seemingly self-sustaining dynamic to an abrupt end. This brings us to the second part of the argument the question of what happens in such a scenario.

Whether they stumbled upon it accidentally or not, it is credible to suggest that governments in Anglophone liberal democracies like the UK and Ireland came to acknowledge the contribution of low interest rates and house price inflation to the economic growth from which they have undoubtedly benefited politically in recent years. And, as such, it is realistic to assume that they now perceive themselves to have a considerable political (and indeed electoral) stake in securing the conditions for a rapid resumption in house-price inflation. This is, of course, immediately interesting. For it suggests a potential conflict of interest with the formally

depoliticised agents of monetary policy the Monetary Policy Committee of the Bank of England and its European Central Bank equivalent. It also suggests that the puncturing of the house price bubble was always likely to pose a political test of the degree to which monetary authorities have indeed been depoliticised. It also suggests, somewhat ironically, that governments (certainly Anglophone liberal governments) may be characterised today rather less by the time-inconsistent inflationary preferences from which central bank independence was designed to protect us, than from increasingly differentiated inflationary preferences. It is the argument of this paper that this is indeed the case. Moreover, and perhaps rather predictably, the European Central Bank has proved itself, rather better able to resist the pressures arising from such preferences, in this regard, than the Bank of England.

But before we explore further the covert repoliticisation of monetary policy in the UK that this suggests, it is important first to examine in some detail the anatomy of the 4

house price bubbles in the UK and Ireland in the years prior to the crisis. It is with the Irish case that we start.

The anatomy of the Irish housing bubble

It is the US housing market, the sub-prime queen and bte-noir of the moment as Mark Blyth puts it (2008: 388), that has attracted most academic and public attention in recent months. Yet it is certainly not the US that has seen the most spectacular increases in housing prices in recent years. That honour if honour it is lies with Ireland, which experienced, between 1997 and 2007, a four-fold increase in the value of its housing stock (at constant prices). Indeed, as Figure 1 shows clearly, Irelands prolonged house price bubble long predates 1997, with prices in Dublin, for instance, having increased some 6-fold between 1990 and the peak in the market in early 2006.

600000 500000 400000 300000 200000 100000 0 1990

1992

1994

1996

1998

2000

2002 Dublin

2004

2006

2008

Ireland

Figure 1: House price inflation in Ireland (average house prices, euros)

Source: Department of Environment, Heritage and Local Government

What this figure also shows is that, despite a 20 per cent fall in value from their peak in 2007, current Irish house prices are still higher than those in the first quarter of 2005. In explaining this, it is useful to look at the more detailed and differentiated picture presented by Figure 2.

58 38 18 -2 2001 -22 -42 -62 % change in house prices % change in mortgage approvals (number) % change in mortgage approvals (value)

2002

2003

2004

2005

2006

2007

2008

2009

Figure 2: Irish house price inflation

Source: calculated from Department of Environment, Heritage and Local Government Note: data show per cent increase on previous year, at quarterly intervals

This shows percentage changes in a range of housing market indices plotted at quarterly intervals, each data point representing the percentage change in the index between a given quarter and the equivalent quarter in the previous year. It

demonstrates a couple of important things. First, it shows just quite how staggering the period of sustained house price inflation in Ireland was with year-on-year increases in the value of new mortgage approvals, for instance, topping 50 per cent in 2002 and returning again to close to that level in 2004. Yet it is what it shows about the down phase that is perhaps most significant. For what it certainly suggests is that in the early phase of the downturn, house prices proved downwardly sticky, with sellers presumably reluctant to accept reductions in asking prices sufficient to secure a sale in a market in which the supply of, and demand for, mortgage loans had fallen precipitously (on downward stickiness in housing prices, see Case and Quigley 2008). Thus, as we shall also see for the UK, it is the volume of housing market transactions rather than the value per transaction that is the first and principal casualty of the ending of the housing boom. In a sense this is alarming. For it suggests that we simply cannot gauge the final impact of the credit crunch and the ensuing crisis on house prices until such time as sellers adjust their expectations to new housing market

conditions - and an increase in the volume of housing transactions will be a first sign that they have done so. It is likely that this process of psychological adjustment will bring with it a significant further fall in prices from current levels.

The determinants of the housing market bubble in Ireland

Having examined the anatomy of the bubble, it is now important that we reflect on the factors that have contributed to its generation and sustenance. Here we must

differentiate between those of a general kind and those specific to the Irish case. As already suggested, the general context for this is set by the liberalisation of global financial markets, the deregulation of domestic credit markets in the liberal market economies and the growth of global liquidity to which this gave rise. Such liquidity has undoubtedly served to precipitate a step reduction in global interest rates and it has also served to stoke a variety of bubbles as institutional investors have flitted from tech stocks to mortgage-backed securities and, more recently still, to commodity and energy markets (for an excellent discussion of both dynamics, see Blyth 2008). For liberal market economies with highly securitised mortgage markets the first of these processes increased the supply of mortgage lending to potential housing marking entrants as well as facilitating the process of equity release in a rising housing market. Both are undoubtedly significant factors in the generation of a largely private debt-financed consumer-led growth dynamic.

But they are by no means the only factors. Here particularly significant has been the impact of the change in monetary policy regime in Ireland with Eurozone entry in 1999. The concern here was always that an interest rate policy set by the European Central Bank for the entire Eurozone was unlikely to prove optimal for Ireland. With respect to the Eurozone Ireland was, as it remains, the outlier inside being, on entry, the fastest growing and the sole liberal market economy in the Eurozone, and one whose business cycle was more closely aligned with that of its two major trading partners, the UK and the US than it was with other prospective entrants (Hay, Riihelinen, Smith and Watson 2008). In this respect it had less to gain and more to lose from Eurozone entry.

Or so one might think. The reality has, in fact, proved rather more complex than such a simple assessment might imply.

Here is it instructive to look at two rather different graphs of inflation performance in recent years for the Irish economy. The first, Figure 3, shows Irish government official inflation data for the period 1998 to 2007 in other words, the period before the impact of the credit crunch on the Irish housing market.

6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 1998 2000 CPI 2002 HICP 2004 2006

HICP-CPI

Figure 3.1.: Irish inflation, 1998-2007

Source: Irish Central Statistics Office

This first graph plots two measures of inflation the traditional consumer prices index (CPI) and the EU Harmonised Index of Consumer Prices (HICP), the official index of inflation within the Eurozone. If we consider first the official HICP data, we see that levels of inflation within the Irish economy since EMU entry (and before the crisis) consistently exceeded the EMU average, peaking at close to 6 per cent in 2000. More recently, they fell back to a low of just under 2 per cent in 2004, but they then rose steadily (at a time when the Irish growth rate was also rising quite steeply). This is quite consistent with the fears of sceptics (and, indeed, some enthusiasts for EMU entry), who anticipated that interest rates set in Frankfurt for the entire Euro-Area were unlikely to be sufficient to control domestic inflationary pressures.

In this context two further factors are worthy of note. First, unsurprising though this is, peaks in Irish inflation within EMU coincide very closely with peaks in rates of economic growth, suggesting that Eurozone interest rates have proved insufficent to control the Irish business cycle and this despite some evidence of business cycle convergence with the Eurozone (Hay, Riihelinen, Smith and Watson 2008a). Second, and more significantly, the graph also shows a substantial and growing disparity whilst the housing boom persisted between the consumer price index, on the one hand, and the EU harmonised index of consumer prices, on the other. Until 2004 or so, there was no discernible trend in the difference between the two plots. Yet thereafter, a clear and growing gap opened up between the CPI and the HICP.

What makes this particularly interesting is that the HICP is a measure of inflation which excludes mortgage interest payments, household insurance premiums and building materials in other words, the principal items in the CPI related to housing (Central Statistics Office 2007: 11). Put simply, the HICP hides the contribution of house price rises to Irish inflation indeed, it redefines inflation in such a way that the increasing costs associated with a rising housing market are deemed non-inflationary. The important point here is that the interest rate settings of the ECB have consistently been lower than those which would have been set by an independent Bank of Ireland with an equivalent remit - lower still than those which would have been set by an independent Bank of Ireland targeting the CPI rather than the HICP. In other words, Irish house price inflation has been fuelled by the sub-optimal character for the Irish economy of the ECBs interest rate settings and by the ECBs preference for a measure of inflation which excludes mortgage interest repayments in particular.

Yet, interesting though this is, it only tells half of the story. Here it is important to examine Figure 3.2 which extends the time-frame to include the bursting of the house price bubble and which shows, in addition to the CPI and HICP, the ECBs interest rate settings over this period.

6.0 4.0 2.0 0.0 2002 -2.0 -4.0 -6.0 CPI HICP ECB Base Rate 2003 2004 2005 2006 2007 2008 2009

Figure 3.2.: Irish inflation and interest rates, 2002-2008

Source: Irish Central Statistics Office

Two features of the graph are particularly important for the broad argument of this paper. First, as might be expected from the preceding discussion, as the housing market slowed (in 2007) and, then contracted (in 2008), the CPI and the HICP converged. Indeed, as one might expect, as deflation took hold (in 2009) they have crossed over and started to diverge (in 2009). Nonetheless, until late 2008, both the CPI and the HICP remained largely unchecked by ECB interest rate settings. With Ireland experiencing negative growth for the first time in three decades from the first quarter of 2008, this was alarming indeed raising the spectre of stagflation for the first time in a very long time. But the key point here for the present analysis is the ECBs hawkishness in pursuit of its counter-inflationary mandate. For, in marked contrast to the UK experience - as we shall see presently - and although insufficient to quell Irish inflationary pressures, the ECB was dogged and consistent in raising interest rates for as long as inflationary pressures persisted within the Eurozone seemingly regardless of the consequences for the housing market and for consumerled growth. As this suggests, and precisely as one would anticipate, whatever the preferences of domestic political elites for a more accommodating monetary stance, the ECB proved itself immune from political influence and true to its mandate of price stability. The same cannot be said of the Monetary Policy Committee of the Bank of England, as we shall see. 10

The implications of this for the Irish economy are interesting. For, should inflation return to the European economy as world growth resumes and a combination of increased demand and speculation drive up fuel and commodity prices - the Irish government cannot expect an accommodating monetary policy stance from the ECB. And that, in turn, places the burden on injecting demand into the housing market on domestic fiscal stimuli which are very difficult to countenance given the level of public debt at present. This may make the present Irish predicament appear somewhat intractable, the Irish economy precariously placed. But three factors perhaps qualify any such pessimism. First, though equity release has been an important mechanism of consumer-led growth in the Irish economy in recent years, it is by no means the only factor, nor it is the most significant determinant of Irelands growth trajectory in recent years. The Irish economy can grow again in the absence of house price inflation (see also Honohan 2009). Second, the ECBs hawkishness with respect to Eurozone inflation led the Euro as a currency to appreciate markedly against the dollar, sterling, the yen and, albeit to a lesser extent, the Chinese yuan. This

undoubtedly helped to control Eurozone inflation in 2007 and 2008, since the price of its imports from major non-Euro trading partners invariably fell. It also served to cushion the burden of rising commodity and energy prices and it might credibly do so again. Finally, there is nothing terribly unusual about Irish inflationary pressures remaining uncontrolled by Eurozone interest rates; nor is there anything worryingly unprecedented about interest rates at 4 or 5 per cent (and it is difficult to imagine that they might be higher any time soon). Indeed, with any historical perspective, interest rates below 5 per cent are low by Irish standards. As this suggests, whilst any future interest rate hikes are likely to prove unpalatable to Irish homeowners at a time of rising domestic prices, it would be wrong to see the ECBs interest rate settings as the key determinant of the future trajectory of house prices and consumer-led growth in Ireland, far less the economys prospects for growth.

The anatomy of the UK housing bubble

The UK housing bubble is, in many respects, very similar in its anatomy and, indeed, in its determinants, to the Irish case already considered. Yet arguably it is the respects

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in which it differs that are most crucial to understanding the implications for macroeconomic stability and the prospects for the resumption of economic growth.

As for the Irish case, it is instructive first to look at the simple trend in house prices over time. This is displayed in Figure 4, which plots percentage changes over a year in house prices, at quarterly or monthly intervals from 1986 to the present day.

25 20 15 10 5 0 -5 -10 -15 -20 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Figure 4: UK house price inflation, 1986-2008

Note: data show percentage increase on previous year, at quarterly or monthly intervals Source: HM Treasury Pocket Databank (August 2008); Halifax House Price Index

It shows very clearly the house price boom of the late 1980s and the longer period of house price inflation following the UKs forcible ejection from the European Exchange Rate Mechanism on Black Wednesday in September 1992 (see also Watson 2008a). It shows also that although the rate of house price growth has slowed at various point (1988-9, 1997-8, 2003-5, 2007-9), it is only twice in the last twenty years (1990-1994 and since 2008) that house prices have actually fallen. It reveals, too, the uninterrupted and near exponential increase in house prices between 1995 and 2003. During this time not only did house price rise year-on-year, but they did so at an ever-increasing rate, as indeed they did again between 2005 and 2007. Finally, the graph shows just how rapidly the condition of the housing market has deteriorated since the third quarter of 2007, with house prices in 2008 falling at a level unseen certainly in recent UK history. 12

Yet the price trend by no means reveals the full picture. Here it is instructive to examine Figure 5, which gives an indication of the volume and capital value of housing market transactions over the period 2002 to 2009.

1500 210 number of transactions 1300 value of transactions 1100 900 700 500 300 2002 190 170 150 130 110 90 70 2003 2004 2005 2006 2007 2008 50 2009

value of housing transactions

number of housing transactions

Figure 5: UK housing market transactions (volume and value of stamp duty receipts) 1
Source: HM Revenue and Customs Annual Receipts (monthly values, 000s and Ms)

What this shows, particularly when considered alongside the previous graph, is that it is the volume of housing market transactions that was hit first as housing conditions worsened. As with the Irish case, it seems, house prices in the UK proved Consequently, until such time as sellers re-adjust their

downwardly sticky.

expectations to the new market conditions and the number of housing transactions starts to recover, it is difficult to gauge the level to which prices will fall. Thus, their recent mild recovery notwithstanding, they may well have some considerable distance still to travel. It would certainly be wrong to infer from a seeming stabilisation of prices based on such a low level of transactions that the worst is already over for the UK housing market.

Since Stamp Duty is only payable on properties over 125,000, these figures in fact underestimate

(and, when differential rates of Stamp Duty are factored into the equation, distort somewhat) the actual volume and value of housing market transactions. They nonetheless provide the best available guide to the level of housing market activity over time.

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The transformation in personal fortunes that this kind of reversal in the housing market represents is easy to illustrate. Consider, for instance, the situation in

November 2006 when the average house price in the UK topped 200,000 for the first time. At that point average annual earnings were about 30,000 and house prices were increasing at an annual rate of 11 per cent. In effect, the wealth effect associated with house price inflation was the equivalent of three quarters of pre-tax annual average earnings. Unremarkably, for many this proved an irresistible incentive to release equity to fuel consumption. Our own calculations suggest that such creditbased consumption was, between 2004 and 2006 typically worth between 4 and 6 per cent of GDP or, in other words, responsible in and of itself for keeping the UK economy in growth at what most would see as a relatively high point in the economic cycle (Hay, Smith and Watson 2006).

Now consider the situation in June 2008. At this point, the average house price (now 218,000) had fallen, according to the Halifax house price index, by 8.9 per cent in the preceding 12 months. Thus, instead of a net wealth effect of 75 per cent of average earnings, the equity of the average wage earner in the average property had fallen by 19,400 - or 65 per cent of annual pre-tax earnings - in a year. Indeed, if one repeats the calculation for December 2008 (by which time the average house had fallen to 195,000), the average property had fallen in value by 124 per cent of average annual pre-tax earnings in the preceding year.

It is, of course, important to put this in the proper context. For all but the most recent entrants to the housing market and those unfortunate enough to release all the equity they had build up in their property at the peak of the housing boom, this drop in house prices was insufficient to pitch them into a position of negative equity (for prices had simply risen so rapidly as the bubble inflated). But such net wealth effects

undoubtedly had a massive impact on consumption with consumers extremely reluctant to extend further their indebtedness, certainly to fund current consumption. And that brings us to the crux of the matter. For the point is that it was precisely this process of equity release that has been responsible to a significant extent for the UKs sustained period of personal debt-financed consumer-led economic growth since 1992.

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But even this is to present too simple a picture. For this is not just a story of a lack of demand for additional lending. For had home-owners wanted to release the remaining equity they had to augment their consumption potential, all the evidence suggests that they would have found it increasingly difficult to do so with commercial lenders reluctant to take on new business and, where they were prepared to do so, demanding higher deposits, charging higher arrangement fees and expecting an increasing interest rate premium over the base rate. In other words, there were and there remain - both supply and demand-side factors bearing down on debt-financed consumer spending in the UK. Neither component of the squeeze is likely to weaken any time soon, as is demonstrated very clearly in Figure 6.

12000 house purchases and remortgaging (M) 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 2002 2003 2004 2005 2006 2007 2008 2009 900 700 500 2100 1900 1700 1500 1300 1100 equity release (M)

house purchases

remortgaging

equity release

Figure 6: UK lending secured against dwellings - 2002-2009 (sa)

Source: British Bankers Association Monthly Statistical Releases

The graph shows the capital value of new lending in the UK secured against property between 2002 and 2009 (sadly, there is no equivalent publicly accessible data for Ireland). But what is most interesting about this data series is that it displays the pattern of new lending in a disaggregated way allowing us, in particular, to look at the relative value of new loans secured for house purchases and equity release. It shows the staggering rise in levels of equity release between 2002 and 2004 and the sharp decline thereafter. At its peak, between 2003 and 2004, 1 in every 6 of new

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lending secured in the UK against property represented the release of equity. Moreover, at this time levels of equity release were the equivalent of 2.5 per cent of GDP and, if we add in new unsecured loans, the figure rises to close to 4 per cent of GDP. Yet since that time, levels of equity release have fallen quite precipitously in two separate periods the first, between 2004 and 2005, the second starting in the final quarter of 2007. Levels of equity release are now the equivalent of 0.4 per cent of GDP (0.7 per cent if we include new unsecured loans) and their value continues to fall.

As this suggests, the throughput from the housing market to consumption which sustained the UK economy throughout the 1990s and, indeed, until very recently has been severed. For an economy which has relied so heavily on both consumer-driven growth and high and rising levels of service-sector employment in a highly flexible labour-market, this is extremely alarming, as an analysis of the determinants of the rise and demise of the housing bubble shows all too clearly.

The determinants of the UK house price bubble

The clear danger is that what had become a self-sustaining and mutually-reinforcing virtuous circle threatened, by early 2008, to become a vicious circle. The fear was that a combination of largely exogenous inflationary factors and, again, largely exogenous shocks to liquidity in the market for mortgage-backed securities would combine - or, indeed, were already combining - to deplete homeowners of the equity they had built up in their properties (and to access to any equity that remained). At a time of rising commodity, fuel and energy prices as in the first half of 2008 - and even in the absence of interest rate hikes to control inflation, this was always likely to reduce significantly disposable personal income. The first casualty in such a context, inevitably, was discretionary consumption (typically, of services). For an economy like the UK, this was disastrous, in two respects in particular. First, as already noted, the growth dynamic of the UK economy in recent years had been predicated - to an extent probably unprecedented amongst other leading economies - on the provision of services to a property-owning consumer society with high levels of (liquid) positive equity and/or disposable income. By mid 2008, even in the absence of interest rate hikes to control inflation, neither condition continued to hold with disposable 16

income squeezed by rising bills and prices and positive equity both depleted and less accessible than previously.

Yet what has compounded this already bleak picture is a second factor, not much discussed in the context of the existing literature whether academic or popular. That is the profoundly pro-cyclical character of New Labours political economy (for more details of which, see Hay 2004, 2006). Especially significant, here, is the mantra and, indeed, the reality of labour-market flexibility. This, of course, is something of a boon when times are good, demand is high, and the economy is growing for it allows demand to be matched by capacity, generating additional employment and preventing over-heating. Yet, by the same token, when demand falls it is easier in a flexible labour market to lay off those whose labour is no longer required. In effect, labour-market flexibility stretches peak-to-trough variations in growth rates and levels of employment. As recession loomed, that was something the UK economy could well have done without. For at the point at which the service sector contracts in response to falling demand, a series of self-reinforcing dynamics are unleashed as those laid-off fail to keep up with their mortgage repayments, cut back their consumption to the bear essentials and, in the process, contribute further to both the shortfall of demand in the economy and to a falling housing market.

This was precisely the situation in which the UK economy found itself by mid 2008. Consequently, it is hardly surprising that, as Figure 8 shows, levels of both consumer confidence and confidence in service sector and manufacturing profitability had fallen so staggeringly low.

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60 40 20 0 2001 -20 -40 -60 Service Manufacturing Consumer

2002

2003

2004

2005

2006

2007

2008

2009

Figure 8: UK service, manufacturing and consumer confidence (20001-2009)

Source: HM Treasury Pocket Databank (July 2008); BCC Quarterly Economic Survey Note: for services and manufacturing, confidence in sector profitability

This is the context, I would suggest, in which we must locate the move that I detect towards a covert repoliticisation of monetary policy in the UK. But to understand this, it is necessary to consider the role played by interest rates in the generation, sustenance and, indeed, unravelling of the long housing bubble which the UK had enjoyed since the early 1990s.

Here, again, the comparison with the Irish case is particularly instructive. The general conditions which made possible the steep rise in house prices, and the debt-financed consumer spending boom which this facilitated, are highly conserved between the two cases. They are also well described in the existing literature (see, especially, Blyth 2008; Schwartz and Seabrooke 2008). The relevant context here is set by the growth of liquidity produced by the combination of the liberalisation of world financial markets and the move, led by the Anglo-liberal economies, to deregulated domestic credit markets. As described above, this has undoubtedly contributed to both lower interest rates throughout the advanced liberal economies as well as improving the access of consumers to credit (especially, that secured against property).

But, as for the Irish case, these are by no means the only relevant factors. A series of rather more domestic drivers have also played a significant role. First, by committing 18

itself in opposition to the outgoing Conservative administrations rather restricted public expenditure commitments in 1997, the incoming Blair government found itself with an initially quite sizeable budget surplus for the duration of its first term in office. This allowed it to repay a significant proportion of national debt which both facilitated interest rate reductions and, perhaps more significantly, reduced inflationary expectations whilst increasing the sensitivity of demand in the economy to interest rate variations (see also Watson 2000). In effect, it made modest

inflationary pressures easier to manage without significant increases in interest rates. Rather serendipitously, this served to establish the conditions for a period of strong and non-inflationary growth combined with historically low and stable interest rates.

In the context of a highly liberal and securitised mortgage market and high levels of liquidity in global financial markets, this was always likely to generate significant house price inflation. But it does not quite tell the full story.

The covert repoliticisation of monetary policy in the UK

In December 2003, ostensibly so as to facilitate any subsequent decision to join the Single European Currency, the government revised the Bank of Englands remit, specifically its target for inflation (King 2004). In so doing, it switched from a symmetrical inflation target of 2 per cent for RPIX inflation to a symmetrical target of 2 per cent for CPI inflation (in fact, the EUs Harmonised Index of Consumer Prices, HICP). This went largely unnoticed and is scarcely commented upon in the existing literature (the exception is Watson 2008b).

But in the context of the present discussion it is highly significant for the CPI, of course, excludes mortgage interest repayments. In effect, the Chancellor was

instructing the Governor of the Bank of England and the MPC to ignore house price inflation in determining UK interest rates; and he chose to do so at quite an opportune moment. For, as Figure 9 shows, fuelled by the developing housing bubble, the retail price index and the consumer price index were, at the time, diverging rapidly.

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8 7 6 5 4 3 2 1 0 -1 -2 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

retail price index Bank Rate

consumer price index mortgage rates (composite index)

Figure 9: UK inflation and interest rates, 2000-2009

Note: Official bank rate (2006-2008); Repo rate (2000-2005) Source: Bank of England

This might be seen as the first step in the covert repoliticisation of monetary policy in the UK for it was an unapologetically political intervention by the Chancellor and one which it is difficult not see as motivated less by preparation for possible Eurozone entry (the official justification) than by a desire to keep interest rates down at a time when the former inflation target was consistently being exceeded. That was certainly its effect interest rates in the UK from 2004 onwards have been consistently lower than they would otherwise have been contributing, quite significantly, to the sustenance of the house price bubble from which the government benefited considerably until its implosion in 2007. This would seem to confirm the impression of a government acting not on time-inconsistent inflationary preference, so much as by sectorally-differentiated inflationary preferences a case of retail inflation bad, house price inflation good.

Yet there is a second, more recent and arguably more significant, episode which might also be seen as evidence for the covert repoliticisation thesis. Here it is important to consider in some detail the Bank of Englands management of inflationary pressures since the second quarter of 2006. The contrast with the ECB is both stark and interesting. For, as we saw when considering the Irish case, the ECB continued to exhibit quite hawkish tendencies with respect to the management of Eurozone 20

inflation (whilst such inflation persisted), raising interest rates frequently and consistently from 2006 until the third quarter of 2008 as commodity, fuel and energy prices rose. But the performance of the Bank of England over the same period was very different.

In the second half of 2006 and the first half of 2007, the Bank of England did indeed raise interest rates no fewer than five times. And, judging by the subsequent movement in the consumer price index, it did so with some success. The CPI fell from a peak of 3.1 per cent in March 2007 to 1.8 per cent by August 2007. Yet, thereafter, and even once inflationary pressures had come to exceed their earlier peak (requiring the Governor of the Bank to write to the Chancellor), no equivalent action was taken. Indeed, quite the opposite. During the final quarter of 2007 and the first two quarters of 2008 interest rates fell three times, despite considerable evidence of growing indeed, if anything, accelerating - inflationary pressures.

In the context of the present discussion this is, of course, not difficult to account for. But the point is that it is very difficult to explain such a seeming change in the monetary stance of the Bank without reference to the housing market. In effect, the Bank of England served to cushion a housing market already on the verge of free-fall from the consequences of its own mandate. The Bank, it seems, unlike its ECB counterpart, came to share in the governments disaggregated view of inflationary pressures. And, in so far as this was the case, monetary policy in the UK had been repoliticised, albeit in a rather covert way. The MPC, it seems, had chosen to tear up its own remit and to adopt, instead, one driven solely by the governments understandable desire to secure once again conditions conducive to house-price inflation.

Conclusion: dancing on the edge of the precipice

The UK and Irish housing bubbles are, at the time of writing, still in the process of imploding; and it is, of course, important not to jump too immediately to conclusions about the long-term consequences of processes as they still unfold. Nonetheless, a comparative analysis of the determinants, sustenance and broader macroeconomic consequences of these ultimately unsustainable housing booms is illuminating in a 21

number of respects. In particular, it points to the specificity of the factors that have contributed to a shared trajectory of sustained house price inflation followed by rapid deflation. Both economies have increasingly come to rely upon personal debt-

financed consumer-led economic growth that has in turn depended upon equity release, easy access to credit and, in turn, low interest rates. Yet the specific

constellation of domestic and, indeed, regional factors contributing to low and stable interest rates is different in each case; as, of course, is the institutional context in which the bursting of the bubble has played out.

In the Irish case there is absolutely no prospect of a rapid resumption in house price inflation arising from an accommodating monetary stance from the ECB. Monetary policy remains, and is likely to continue to remain, both doggedly hawkish in the face of inflationary pressures (as and when they resume) and resolutely depoliticised. But this may well be no bad thing for the Irish economy. For, although Eurozone interest rates are likely to rise as and when growth in the world economy resumes, they are still likely to remain low by historical Irish standards. Moreover, the strengthening of the Euro to which the ECBs monetary stance has undoubtedly contributed may help to hold down commodity, energy and fuel prices relative to many of Irelands competitors. Finally, as I have sought to demonstrate, though a significant contributor to Irish growth in recent years, the housing market and the equity release that it has allowed, is better seen as a catalyst to growth rather than a key determinant of growth per se. Unlike the UK, it is plausible to think that the Irish economy can grow in the absence of re-establishing the conditions of house price inflation.2

The UK context is rather different and the prognosis potentially rather more alarming. Here, it seems, much was invested in the capacity of the Bank of England - pursuing what can surely only be seen as a covertly repoliticised monetary policy at odds with its official mandate - to cushion the impact of stagflationary pressures on the housing market.
2

The problem, of course, is that the Euro has appreciated significantly against the currencies of

Irelands two principal trading partners, the UK and the US at a time of falling demand in both. Thus, Irelands manufacturing-driven export growth dynamic and its credit-fuelled consumption driven growth dynamic are both in crisis. It is, nonetheless, far better placed to benefit from a resumption of growth in the world economy than in the UK economy.

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Of course, now that the recession has fully taken hold inflation is no longer the problem. But there are reasons for thinking that it is likely to re-emerge as problem at precisely the point at which growth resumes. And the worry is that, should it do so, the Bank has no capacity to control such inflation without pitching the economy back into recession.

So what is it that makes the return of inflation so likely at the point at which growth in the world economy resumes? In short, a factor alluded to earlier the almost

unprecedented volatility injected into world oil prices by their increasingly speculative character. Oil prices are, of course, remarkably low at present and it is the rapid fall that brought this about that is largely responsible for stagflation in Britain giving way to recession without any intervening interest rate rises. This has certainly helped the Bank, which must have feared having to return to a more hawkish disposition had continued stagflation precipitated a major run on the currency.

But the point is that it may also serve to trap the UK economy in recession. For, as and when growth returns to the world economy, oil prices will surely rise and in a highly speculative and accordingly volatile world energy market, this rise is likely to be steep. The result, merely exacerbated by the weakness of sterling, is almost inevitably an inflationary spike and a fresh headache for the Monetary Policy Committee of the Bank of England. Its mandate tells it, in such a situation, to raise interest rates and to control inflation. But, given the strength of the link between house price inflation and growth in the UK economy since the early 1990s (Case, Quigley and Shiller 2005), and the sensitivity of the housing market to interest rates, this is almost bound to push the economy back into recession. Yet deferring interest rate rises and cushioning the housing market against exogenous inflation merely risks a further run on the currency, necessitating the more brutal return to a hawkish disposition at a later date. Such a run on the currency would, of course, only

exacerbate further the inflationary pressures arising from the escalating costs of imported commodities, energy and fuel.

Painted in these rather bleak and admittedly broad brush strokes, it is increasingly difficult to see how, in the absence of a new growth model for the UK economy, 23

future inflation can now be controlled without pushing the economy (back) into recession. From the final quarter of 2007 through the first two quarters of 2008, the Bank simply deferred the problem of dealing with inflation; and it is easy to see why. But the problem is likely to return. Growth in the UK is now perilously closely bound up with the availability of credit and the release of equity and both of these are now highly sensitive to interest rates variations. This makes the covert repoliticisation of monetary policy in the UK that we have seen in recent years entirely understandable; but it does not make it any less risky. We have, it seems, been dancing on the edge of a precipice and the music has not yet stopped.

References

Blyth, M. (2008) The Politics of Compounding Bubbles: The Global Housing Bubble in Comparative Perspective, Comparative European Politics, 6 (3), 387-406. Case, K. E. and Quigley, J. M. (2008) How Housing Booms Unwind: Income Effects, Wealth Effects and Feedback Through Financial Markets, European Journal of Housing Policy, 8 (2), 161-80. Case, K. E., Quigley, J. M. and Shiller, R. J. (2005) Comparing Wealth Effects: The Stock Market Versus the Housing Market, Advances in Macroeconomics, 5 (1), 1-32. Central Statistics Office (2007) Consumer Price Index: January 2007. CSO: Dublin. Hay, C. (2004) Credibility, Competitiveness and the Business Cycle in Third Way Political Economy, New Political Economy, 7 (1), 39-57. Hay, C. (2006) Managing Economic Interdependence, in P. Dunleavy, R. Heffernan, P. Cowley and C. Hay (eds.) Developments in British Politics 8. Basingstoke: Palgrave Macmillan. Hay, C. Riihelinen, J. M. Smith, N-J. and Watson, M.(2008) Ireland: The Outlier Inside, in K. Dyson (ed.) The Euro at Ten: Europeanisation, Power and Convergence. Oxford: Oxford University Press. Hay, C., Smith, N-J. and Watson, M. (2006) Beyond Prospective Accountancy: Reassessing the Case for British Membership of the Single European Currency Comparatively, British Journal of Politics and International Relations, 8 (1), 101-21. Honohan, P. (2009) Resolving Irelands Banking Crisis, The Economic and Social Review, 40 (2), 207-31. King, M. (2004) Speech to the Annual Birmingham Forward/CBI Business Luncheon, Villa Park, 20 January. Schwartz, H. (2008) Housing, Global Finance and American Hegemony: Building Conservative Politics One Brick at a Time, Comparative European Politics, 6 (3), 262-84. Schwartz, H. and Seabrooke, L. (2008) Varieties of Residential Capitalism in the International Political Economy: Old Welfare States and the New Politics of Housing, Comparative European Politics, 6 (3), 237-61.

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Watson, M. (2000) The Political Discourse of Globalisation: Globalising Tendencies as Self-Induced External Enforcement Mechanisms. Unpublished PhD Thesis, University of Birmingham. Watson, M. (2008a) Constituting Monetary Conservatives via the Savings Habit: New Labour and the British Housing Market Bubble, Comparative European Politics, 6 (3), 285-304. Watson, M. (2008b) The Split Personality of Prudence in the Political Economy of New Labour, Political Quarterly, 79 (4), 578-89. Wyss, D. (2007) The Subprime Market: Housing and Debt, Standard and Poors Research, 15 March.

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