Ever since this column started in 2000, I have been writing that British house property is hopelessly overpriced. There is no question this has been spectacularly bad investment advice – Londoners who owned a home in 2000 have at least trebled their money since then, doubling it in real terms. Nevertheless, it is possible for an asset to remain overvalued for decades, and I would like to examine the damage that overpriced real estate has done to Britain’s economy.

The initial impulse for the column arose when I discovered that my grandparents’ very modest semi-detached house in Bristol, where I spent six months of my childhood, was now valued at £740,000 (just under $1 million at today’s exchange rate.) The house was in a fairly nice part of Bristol, near the cricket ground, but it was no more than skilled-artisan housing from the 1900s, with small rooms (3 bedrooms) and a driveway shared with the house next door. Needless to say, my grandfather; a retired Major, could no more have afforded that house at today’s prices than he could have flown to the Moon, At today’s top salary for a Major of £62,132, his maximum borrowing capacity would have been only about £250,000 at most, and he would never have stretched his finances that far.

A recent Dallas Fed study compares house prices from 1899 to 2012 across a number of countries. In the United Kingdom, house prices in real terms fell by 1% per annum from 1899 to 1938, then jumped during World War II (presumably reflecting destruction of part of the supply) and began a moderate real price increase thereafter, which accelerated to a mad spiral in the 1990s and 2000s. Real house prices across the UK are now roughly double their 1990 level, (1990 being itself at the peak of a bubble) four times their 1970 level and eight times their level in the blissful days of 1938.

Two factors account for part of this increase. First, there is a modest hedonic improvement in the quality of the item known as a “house.” Houses built in 1899 quite often had outside privies, although my grandparents’ house, built a little later than that, had modern plumbing, albeit not very much of it by modern standards. The Dallas Fed estimates that the hedonic factor accounts for about a 0.2% per annum price increase. Second, there is an increase in real terms in the wages of construction workers, and hence in the construction costs of houses. This factor has been minor since 1980 or so, but was very important in the decades after World War II, during which in Britain blue-collar wages shot ahead while professional wages stagnated or declined.

However, those factors do not account for anywhere near the overall increase, nor do they account for the exorbitant increases since 1990, especially in southern England and London (my London house is now worth six times what I sold it for in 1994.)

The exorbitant rise in house prices is not universal. In Germany, for example, house prices have declined in real terms since the 1980s, although there was a sharp rise between pre-war and post-war real house prices. In the United States, exorbitant house price rises of the last couple of decades have been concentrated almost entirely in the coastal big cities; small-town house prices have not risen greatly, and still bear a close relationship to construction costs. Even in Britain, the huge price rises have been concentrated in the south; prices in the north of England are much more reasonable, except at the top of the market, where a widening of the income distribution has had its inevitable effect.

Finally, in Japan there was a gigantic and damaging bubble until 1990, but since then real prices have declined by about 3% per annum, so they are now at the level of the late 1960s, half the 1990 peak. As in Britain, the rise and subsequent collapse was heavily concentrated in the capital, although without Britain’s extremes of wealth, Japan never saw the outrageous prices London has seen at the top end.

Where there has been an excessive rise in house prices, it has had a highly damaging effect. Individuals leverage themselves too much, to get onto the “housing ladder,” making them highly reluctant to move to change jobs and preventing them from saving enough for retirement. At the national level, the investment in the relatively unproductive asset of housing is excessive, preventing investment in more productive assets.

You only have to look at the appalling productivity performance of Britain since the 2007 crash to see the damage that excessive borrowing and housing investment does to productivity. In 2016, land represented 51% of British assets, the highest of any country (and historically beaten only by Japan in the early 1990s.) Needless to say, this makes no sense. Britain is an overcrowded island with a high-skill population; the value of its capabilities and the businesses generated from them should far exceed the value of the island’s modest endowment of land. The much larger and somewhat richer Germany has a land value of only 25% of net worth; by what magic is British land worth so much more than German land?

Britain’s balance sheet outside real estate is upside down, with financial net assets slightly negative, i.e. debt exceeding assets. The rise in land and buildings values has increased nominal British net worth, but this is chimerical; once house price revert to their long term average level, a very high proportion of British households will be insolvent, with gigantic mortgages exceeding the shrunken value of their homes.

The examination of the very long-term statistics of the Dallas Fed, and their multi-country comparisons, shows that in Britain in particular, but also in the urban coastal United States, real estate prices have run far ahead of the level that is sustainable, by a factor of at least 2 and in many areas 3 or 4. This suggests that in the next couple of decades these prices will mean-revert savagely. The economic effect of this will be very unpleasant. With the most recent estimate being that half of Britain’s mortgage borrowers have a loan to value ratio of over 70%, then a 50% decline in house prices will leave half the mortgage borrowers more than 40% underwater on their mortgage, producing almost certain default.

This will have an effect across the entire British economy. A financial system in which half of all borrowers are in default on their mortgages, with loans 40% above their home’s value, is a financial system that has lost all its capital, attached to an economy in which credit for productive purposes will be almost unattainable. This would cause a prolonged economic downturn that would make the Great Depression look like a picnic.

There is a way out, but it’s not a pleasant one. The economically unpleasant period of the mid-1970s, when GDP fell sharply and inflation rose to 25%, was relatively short-lived, largely because the inflation bailed out the housing market, which had already become overblown in 1973. Only a similar but more prolonged period of inflation, which will depress real house prices even as nominal house prices decline less, bailing out the mortgage market, will enable the British economy to avoid the truly disastrous situation of mass mortgage default.

Provided the inflation takes place as required, the young will manage to navigate this situation successfully. They will be able to negotiate salary increases, as we were in the 1970s, so that their living standards keep up, more or less, although they may feel pinched. The declining real value of homes will bring more and more possible house purchases into their view, although they may find the landscape very short of mortgage lenders. Since the period of price decline is only beginning, the luckiest will be those too young to have got themselves on the housing ladder at inflated prices, not the silly Millennials, but post-Millennials.

The true losers will be those Baby Boomers who have used their houses as an ATM, re-mortgaging to support their spending profligacy, or who have been relying on their houses as a kind of automatic pension scheme. With inflation racing ahead at 25% per annum and house prices declining, they will find themselves in for a truly penurious retirement.

Thank God I was forced to sell my London house in 1994!

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
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