Housing Boom-UK e Irlanda

Good Inflation, Bad Inflation: TheHousing Boom, Economic Growth andthe Disaggregation of InflationaryPreferences in the UK and Irelandbjpi_380 461..478

Colin Hay

This article presents a comparative analysis of the determinants, sustenance and broader macro-economic consequences of the ultimately unsustainable housing boom in Ireland and the UK inrecent years. It examines, in particular, the role played by ostensibly depoliticised monetary policyin both contexts in the development of a house price bubble that has served to fuel consumer-ledgrowth. It assesses the viability, sustainability and reproducibility of the private debt-financedconsumer boom that house price inflation has generated. In the process it draws attention to theincreasingly differentiated character of both government inflationary preferences and counter-inflationary performancewith the shift to official measures of inflation that exclude mortgageinterest repayments and, in the UK at least, to the covert re-politicisation of monetary policy. Itconcludes by suggesting that governments may well not have time-inconsistent inflationary pref-erences so much as sectorally specific inflationary preferences. This might be summarised in termsof the aphorism: retail price inflation bad, house price inflation good.

Keywords: inflation management; monetary policy; economic growth; economiccrisis

The recent implosion of the house price bubble in the advanced liberal eco-nomies raises serious concerns about macroeconomic management, the counter-inflationary preferences of public authorities in particular. Those concerns areperhaps most acute in the anglophone liberal democracies, whose economies haveexperienced both the largest house price increases and which now seem destined tosuffer the most spectacular downward recalibration in pricesand whose growthstrategy in recent years seems to have rested most heavily on consumption fuelledby equity release in a rising housing market.

This article argues for the merits of a comparative approach to the inflation andpuncturing of the house price bubble in such economies (see also Hay et al. 2006).As it seeks to show, even in ostensibly most similar cases, the determinants of houseprice inflation and deflation in recent years are multiple, complex and differenti-ated. Acknowledging this has important implications for an assessment of thesustainability or unsustainability of the growth trajectories of such economies sincethe early 1990s and the likelihood of a return to sustainable growth in the yearsahead.

The British Journal ofPolitics and International Relations

doi: 10.1111/j.1467-856X.2009.00380.x BJPIR: 2009 VOL 11, 461478

2009 The Author. Journal compilation 2009 Political Studies Association

The basic argument of the article 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 trajec-tory was secured and sustained by historically low interest rates. This served tobroaden access toand to improve affordability withinthe housing market,driving a developing house price bubble. Once established this was sustained, if notperhaps actively nurtured, by interest rates that remained, by recent historicalstandards, unprecedentedly low throughout the boom. Yet, as is now increasinglyacknowledged, it was not just low interest rates that served to inflate the bubble.Crucial, too, was the liberal and highly securitised character of the mortgage marketin both Ireland and the UK (see, especially, Schwartz 2008; Schwartz andSeabrooke 2008; Watson 2008a). In such a context, banks and building societies acteffectively as financial intermediaries, repackaging new loans as mortgage-backedsecurities (MBSs) for institutional investors such as pension funds. The lions shareof their income is generated, not from the interest rate spread between deposits andloans, but from transaction fees. Consequently, they are energetic and often highlyinnovative in offering new mortgage instruments to potential borrowers, confidentin the knowledge that they can pass on any interest rate risk they might otherwisebear to buyers of MBSs. In a rapidly growing housing market, they are also likelyto be a source of capital to fuel consumption for borrowers keen to release theequity they have built up in their property. As Herman Schwartz suggests (2008,263), the disinflation of the 1990s combined with the operation of global capitalmarkets differentially to produce increased aggregate demand in countries charac-terised by widespread home-ownership, high levels of mortgage debt relative toGDP, early refinancing of those mortgages and mortgage securitisation.

That was then. As is well known, a global crisis of confidence in mortgage-backedsecurities, arising initially fromconcerns about thequality of sub-prime lending in theUS, and inflationary pressures associated with rising fuel and commodity prices havebrought this seemingly self-sustaining dynamic to an abrupt end. This brings us to thesecond 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 thatgovernments in anglophone liberal democracies like the UK and Ireland nowacknowledge the contribution of low interest rates and house price inflation to theeconomic growth from which they have undoubtedly benefited politically in recentyears. As such, it is surely realistic to assume that they now perceive themselves tohave a considerable political (and electoral) stake in securing the conditions for arapid resumption in house price inflation (see also Crouch 2009, in this issue). Thisis, of course, immediately interesting. For it suggests a potential conflict of interestwith the formally depoliticised agents of monetary policy: the Monetary PolicyCommittee (MPC) of the Bank of England and its European Central Bank equiva-lent. It also suggests that we are likely to seeif we have not already begun toseea political test of the degree to which monetary authorities have indeed beendepoliticised. It also suggests, somewhat ironically, that governments (certainlyanglophone liberal governments) may be characterised today rather less by thetime-inconsistent inflationary preferences from which central bank independencewas designed to protect us, than from increasingly differentiated inflationary pref-erences. It is the argument of this article that this is indeed the case. Moreover, and

462 COLIN HAY

2009 The Author. Journal compilation 2009 Political Studies AssociationBJPIR, 2009, 11(3)

perhaps rather predictably, the European Central Bank has proved itself ratherbetter able to resist the pressures arising from such preferences, in this regard, thanthe Bank of England.

But before we explore further the covert re-politicisation of monetary policy in theUK that this suggests, it is important first to examine in some detail the anatomy ofthe house price bubbles in the UK and Ireland in recent years. It is with the Irishcase that we start.

The Anatomy of the Irish Housing BubbleIt is the US housing market, the sub-prime queen and bte-noir of the moment asMark Blyth puts it (2008, 388), that has attracted most academic and publicattention in recent months. Yet it is certainly not the US that has seen the mostspectacular increases in housing prices in recent years. That honourif honour itislies with Ireland, which experienced, between 1997 and 2005, a staggering 185per cent increase in house prices (Wyss 2007). Indeed, as Figure 1 shows clearly,Irelands prolonged house price bubble long predates 1997, with prices in Dublin,for instance, having increased some six-fold between 1990 and the peak in themarket in early 2006.

What this figure also shows is that, despite considerable concern about risinginflation, falling growth and less favourable conditions for new borrowers followingthe sub-prime crisis, average house prices in Ireland have thus far lost less than 8per cent of their peak value.1 Put slightly differently, prices in the first quarter of2008 were in fact rather higher than those in the first quarter of 2006, only sixmonths before the peak in the housing bubble. In explaining this, it is useful to lookat the more detailed and differentiated picture presented by Figure 2.

This shows percentage changes in a range of housing market indices plotted atquarterly intervals, each data point representing the percentage change in the index

Figure 1: House Price Inflation in Ireland (Average House Prices, Euros)

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1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Ireland Dublin

Source: Department of Environment, Heritage and Local Government

GOOD INFLATION, BAD INFLATION 463


between the present quarter and the equivalent quarter in the previous year. Itdemonstrates a couple of important things. First, it shows just how staggering theperiod of sustained house price inflation in Ireland waswith year-on-yearincreases in the value of new mortgage approvals, for instance, topping 50 per centin 2002 and returning again to close to that level in 2004. Yet it is what it showsabout the down phase that is perhaps most significant. For what it certainly suggestsis that house prices have proved downwardly sticky, with sellers presumably reluc-tant to accept reductions in asking prices sufficient to secure a sale in a market inwhich the supply of, and demand for, mortgage loans has fallen sharply (ondownward stickiness in housing prices, see Case and Quigley 2008). Thus, as weshall also see for the UK, it is the volume of housing market transactions rather than thevalue per transaction that is the first and principal casualty of the ending of the Irishhousing boom. In a sense this is alarming. For it suggests that house prices have along way still to fall. Put simply, we cannot gauge the likely impact of the creditcrunch and inflationary tendencies on house prices until such time as sellers adjusttheir expectations to new housing market conditionsand an increase in thevolume of housing transactions will be the first sign that they have done so. It islikely that this process of psychological adjustment will bring with it a significant fallin prices from current levels.

The Determinants of the Housing MarketBubble in IrelandHaving examined the anatomy of the bubble, it is now important that we reflect onthe factors that have contributed to its generation and sustenance. Here we must be

Figure 2: Irish House Price Inflation

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2001 2002 2003 2004 2005 2006 2007 2008

% change in house prices

% change in mortgage approvals (number)

% change in mortgage approvals (value)

Source: Calculated from Department of Environment, Heritage and Local Government

Note: Data show per cent increase on previous year, at quarterly intervals

464 COLIN HAY


careful to differentiate between general trends and those specific to the Irish case.As already suggested, the general context for this is set by the liberalisation of globalfinancial markets, the deregulation of domestic credit markets in the liberal marketeconomies and the growth of global liquidity to which this gave rise. Such liquidityhas undoubtedly served to precipitate a step reduction in global interest rates andit has also served to stoke a variety of bubblesas institutional investors have flittedfrom tech stocks to mortgage-backed securities and now into commodity andenergy markets (for an excellent discussion of both dynamics, see Blyth 2008). Forliberal market economies with highly securitised mortgage markets this hasincreased the supply of mortgage lending to potential housing marking entrants aswell as facilitating the process of equity release in a rising housing market. Both areundoubtedly significant factors in the generation of a largely private debt-financedconsumer-led growth dynamic.

But they are by no means the only factors. Here particularly significant has been theimpact of the change in monetary policy regime in Ireland with Eurozone entry in1999. The concern here was always that an interest rate policy set by the EuropeanCentral Bank for the entire Eurozone was unlikely to prove optimal for Ireland.With respect to the Eurozone Ireland was, as it remains, the outlier insidebeing,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 majortrading partners, the UK and the US than it was with other prospective entrants(Hay et al. 2008). In this respect it had less to gain and more to lose from Eurozoneentry.

Or so one might think. The reality has, in fact, proved rather more complex thansuch a simple assessment might imply. Here it is instructive to look at two ratherdifferent graphs of inflation performance in recent years for the Irish economy. Thefirst, Figure 3a, shows Irish government official inflation data for the period 1998 to2007in other words, the period before the impact of the credit crunch on the Irishhousing market.

Figure 3a: Irish Inflation, 19982007

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4.0

5.0

6.0a

1998 2000 2002 2004 2006

CPI HICP HICP-CPI

Source: Irish Central Statistics Office



This first graph plots two measures of inflation: the traditional consumer pricesindex (CPI) and the EU Harmonised Index of Consumer Prices (HICP), the officialindex of inflation within the Eurozone. If we consider first the official HICP data, wesee that levels of inflation within the Irish economy since EMU entry have quiteconsistently exceeded the EMU average, peaking at close to 6 per cent in 2000.Since that time, they have fallen to a low of just under 2 per cent in 2004, but theyhave risen steadily since (at a time when the Irish growth rate has also risen quitesteeply). This is quite consistent with the fears of sceptics (and, indeed, someenthusiasts for EMU entry), who anticipated that interest rates set in Frankfurt forthe entire euro area were unlikely to be sufficient to control domestic inflationarypressures.

In this context two further factors are worthy of note. First, unsurprising thoughthis is, peaks in Irish inflation within EMU coincide very closely with peaks in ratesof economic growth, suggesting that Eurozone interest rates have proved insuffi-cient to control the Irish business cycleand this despite some evidence of businesscycle convergence with the Eurozone (Hay et al. 2008). Second, and more signifi-cantly, the graph also shows a substantial and growing disparity between theconsumer price index, on the one hand, and the EU harmonised index of consumerprices, on the other. Until 2004 or so, there was no discernible trend in thedifference between the two plots. Yet, more recently, a clear and ever-growing gaphas opened up between the CPI and the HICP.

What makes this particularly interesting is that the HICP is a measure of inflationthat excludes mortgage interest payments, household insurance premiums andbuilding materialsin other words, the principal items in the CPI related to housing(Central Statistics Office 2007, 11). Put simply, the HICP hides the contribution ofhouse price rises to Irish inflationindeed, it redefines inflation in such a way thatthe increasing costs associated with a rising housing market are non-inflationary.The important point here is that the interest rate settings of the ECB have consis-tently been lower than those that would have been set by an independent Bank ofIreland with an equivalent remitlower still than those that would have been setby an independent Bank of Ireland targeting the CPI rather than the HICP. In otherwords, Irish house price inflation has been fuelled by the suboptimal character forthe Irish economy of the ECBs interest rate settings and by the ECBs preference fora measure of inflation that excludes mortgage interest repayments in particular.

Interesting though this is, it only tells half of the story. Here it is important toexamine Figure 3b, which extends the time frame to include the bursting of thehouse price bubble and shows, in addition to the CPI and HICP, the ECBs interestrate settings over this period. Two features of this graph are particularly importantfor the broad argument of this article. First, as might be expected from the precedingdiscussion, as the housing market has slowedand, indeed, contractedthe CPIand the HICP have converged. Nonetheless, both continue a steep upward trajec-tory seemingly unchecked by ECB interest rate settings. With Ireland experiencingnegative growth for the first time in three decades in the first quarter of 2008, thisis alarming indeedraising the spectre of stagflation for the first time in a very longtime. But the key point here for the present analysis is the ECBs hawkishness inpursuit of its counter-inflationary mandate. For, in marked contrast to the UK

466 COLIN HAY


experienceas we shall see presentlyand although insufficient to quell Irishinflationary pressures, the ECB has been dogged and consistent in raising interestrates as inflationary pressures have built, seemingly regardless of the consequencesfor the housing market and for consumer-led growth. As this suggests, and preciselyas one would anticipate, whatever the preferences of domestic political elites for amore accommodating monetary stance, the ECB has proved itself immune frompolitical influence and true to its mandate of price stability. The same cannot besaid of the Monetary Policy Committee of the Bank of England, as we shallsee.

The implications of this for the Irish economy are interesting. The Irish governmentcan expect no reduction in interest rates while the inflationary pressures associatedwith rising fuel and commodity prices persist. And it seems, at present, reluctant touse fiscal stimuli to inject demand into the housing market. This may make thepresent Irish predicament sound intractable, the Irish economy precariously placed.But three factors perhaps qualify any such pessimism. First, though equity releasehas been an important mechanism of consumer-led growth in the Irish economy inrecent years, it is by no means the only factor, nor is it the most significantdeterminant of Irelands growth trajectory in recent years. The Irish economy cangrow again in the absence of house price inflation. Second, the ECBs hawkishnesswith respect to Eurozone inflation has led the euro as a currency to appreciatemarkedly against the dollar, sterling, the yen and, albeit to a lesser extent, theChinese yuan. This has undoubtedly helped to control inflation, since the price ofits imports from major non-euro trading partners has invariably fallen and it hasalso served to cushion the burden of rising commodity and energy prices. Finally,there is nothing terribly unusual about Irish inflationary pressures remaininguncontrolled by Eurozone interest rates; nor is there anything worryingly unprec-edented about interest rates at 4.25 per cent. Indeed, with any historical perspec-tive, interest rates below 5 per cent are low by Irish standards. As this suggests,

Figure 3b: Irish Inflation and Interest Rates, 200208

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b

2002 2003 2004 2005 2006 2007 2008

CPI HICP ECB Base Rate

Source: Irish Central Statistics Office



while any interest rate hike is likely to be unpalatable to homeowners at a time ofrising domestic prices, it would be wrong to see the ECBs interest rate settings asthe key determinant of the future trajectory of house prices and consumer-ledgrowth in Ireland.

The Anatomy of the UK Housing BubbleThe 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 isthe respects in which it differs that are most crucial to understanding the implica-tions for macroeconomic stability and the prospects for the resumption of economicgrowth.

As it was for the Irish case, it is instructive first to look at the simple trend in houseprices over time. This is displayed in Figure 4, which plots percentage changes overa year in house prices, at quarterly or monthly intervals from 1986 to the presentday. It shows very clearly the house price boom of the late 1980s and the longerperiod of house price inflation following the UKs forcible ejection from the Euro-pean Exchange Rate Mechanism on Black Wednesday in September 1992 (see alsoWatson 2008a). It shows also that although the rate of house price growth hasslowed at various points (198889, 199798, 200305, 200709), it is only twice inthe last 20 years (199094 and since 2008) that house prices have actually fallen.It reveals, too, the uninterrupted and near exponential increase in house pricesbetween 1995 and 2003. During this time not only did house prices rise year onyear, but they did so at an ever-increasing rate, as indeed they did again between2005 and 2007. Finally, the graph shows just how rapidly the condition of thehousing market has deteriorated since the third quarter of 2007, with house pricescurrently falling at a level unseen in the UK in the previous two decades.

Figure 4: UK House Price Inflation, 19862008

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1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 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

468 COLIN HAY


Yet the price trend by no means reveals the full picture. Here it is instructive toexamine Figure 5, which gives an indication of the volume and capital value ofhousing market transactions over the period 2002 to 2008. What this shows,particularly when considered alongside the previous graph, is that it is the volumeof housing market transactions that is hit first as housing conditions worsen. Aswith the Irish case, it seems, house prices in the UK have proved downwardlysticky, though there is perhaps greater evidence from the most recent UK data that,despite still declining housing market activity, prices are now beginning to fallprecipitously. Until such time as sellers readjust their expectations to the newmarket conditions and the number of housing transactions starts to recover, it isdifficult to gauge the level to which prices will fallbut they clearly have someconsiderable distance still to travel.

The transformation in personal fortunes that this kind of reversal in the housingmarket represents is easy to illustrate. Consider, for instance, the situation inNovember 2006 when the average house price in the UK topped 200,000 for thefirst time. At that point average annual earnings were about 30,000 and houseprices were increasing at an annual rate of 11 per cent. In effect, the wealth effectassociated with house price inflation was the equivalent of three quarters of pre-taxannual average earnings. Unremarkably, for many this proved an irresistible incen-tive to release equity to fuel consumption. Our own calculations suggest that suchcredit-based consumption was, between 2004 and 2006, typically worth between 4and 6 per cent of GDPor, in other words, responsible in and of itself for keepingthe UK economy in growth at what most would see as a relatively high point in theeconomic cycle (Hay et al. 2006).

Now consider the situation in June 2008. At this point, the average houseprice (now 218,000) had fallen, according to the Halifax house price index, by

Figure 5: UK Housing Market Transactions (Volume and Value of Stamp DutyReceipts)2

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2002 2003 2004 2005 2006 2007 2008

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of tr

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value of housing transactions number of housing transactions

Source: HM Revenue and Customs Annual Receipts (monthly values, 000s and ms)



8.9 per cent in the preceding 12 months. Thus, instead of a net wealth effect of75 per cent of average earnings, the equity of the average wage earner in theaverage property had fallen by 19,400or 65 per cent of annual pre-taxearningsin a year. It is, of course, important to put this in the proper context. Forall but the most recent entrants to the housing market and those unfortunateenough to release all the equity they had built up in their property at the peak ofthe housing boom, this drop in house prices was insufficient to pitch them into aposition of negative equity. But, at a time of rapidly rising commodity and energyprices, it is very likely to alter significantly their desire to extend further theirindebtednesscertainly to fund current consumption. But the point is that it isprecisely this process of equity release that has been responsible to a significantextent for the UKs sustained period of personal debt-financed consumer-led eco-nomic growth since 1992.

Yet this is not just a story of a lack of demand for additional lending. For had theywanted to release equity, all the evidence suggests that they would have found itincreasingly difficult to do sowith commercial lenders reluctant to take on newbusiness and, where they were prepared to do so, demanding higher deposits,charging higher arrangement fees and expecting an increasing interest ratepremium over the base rate. In other words, there is both a supply-side and ademand-side squeeze on debt-financed consumer spending in the UK todayandneither component of the squeeze is likely to weaken any time soon. This isdemonstrated very clearly in Figure 6.

The graph shows the capital value of new lending in the UK secured againstproperty between 2002 and 2008 (sadly, there is no equivalent publicly accessibledata for Ireland). But what is most interesting about this data series is that it displaysthe pattern of new lending in a disaggregated wayallowing us, in particular, to

Figure 6: UK Lending Secured against Dwellings: 200209

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house purchases remortgaging equity release

Source: British Bankers Association Monthly Statistical Releases

470 COLIN HAY


look at the relative value of new loans secured for house purchases and equityrelease. It shows the staggering rise in levels of equity release between 2002 and2004 and the sharp decline thereafter. At its peak, between 2003 and 2004, 1 inevery 6 of new lending secured in the UK against property was solely for therelease of equity. Moreover, at this time levels of equity release were the equivalentof 2.5 per cent of GDPand, if we add in new unsecured loans, the figure rises toclose to 4 per cent of GDP. Yet since that time, levels of equity release have fallenquite precipitously in two separate periods: the first, between 2004 and 2005; thesecond starting in the final quarter of 2007 and still ongoing. Levels of equityrelease are now the equivalent of 0.5 per cent of GDP (0.8 per cent if we includenew unsecured loans) and their value continues to fall rapidly.

As this suggests, and as Figure 7 confirms, the composition of lending securedagainst property in the UK has changed very significantly since the onset of thecredit crunch. The mortgage market is now dominated by remortgaging, withthe proportion of new lending accounted for by equity release and new housepurchases combined falling well below 50 per cent (whether gauged in terms ofvolume or capital value of new loans secured). As this suggests, the throughputfrom the housing market to consumption that sustained the UK economy through-out the 1990s and, indeed, until very recently has been severed. For an economythat has relied so heavily on both consumer-driven growth and high and risinglevels of service-sector employment in a highly flexible labour market, this isextremely alarming, as an analysis of the determinants of the rise and demise of thehousing bubble shows all too clearly.

The Determinants of the UK House Price BubbleThe clear danger is that what had become a self-sustaining and mutually reinforcingvirtuous circle now threatens to become a vicious circle. The fear must be that a

Figure 7: The Composition of New Mortgage Lending in the UK (Percentage ofTotal, by Number of New Loans)

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2002 2003 2004 2005 2006 2007 2008

house purchases remortgaging equity release



combination of largely exogenous inflationary factors and, again, largely exogenousshocks to liquidity in the market for mortgage-backed securities will deplete theequity homeowners had built up in their properties (as well as access to any equitythat remains) (see also Finlayson 2009, in this issue). At a time of rising commodity,fuel and energy pricesas in the first half of 2008and even in the absence ofinterest rate hikes to control inflation, this was always likely to reduce significantlypersonal disposable income. The first casualty in such a context, inevitably, isdiscretionarytypically, service-sectorconsumption. For an economy like theUK, this is disastrous, in two respects in particular. First, as already noted, thegrowth dynamic of the UK economy in recent years has been predicatedto anextent probably unprecedented among other leading economieson the provisionof 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 ofinterest rate hikes to control inflation, neither condition continued to holdwithdisposable income squeezed by rising bills and prices and positive equity bothdepleted and less accessible than previously.

Yet what has compounded this already bleak picture is a second factor, not muchdiscussed in the context of the existing literaturewhether academic or popular.That is the profoundly pro-cyclical character of New Labours political economy (formore details of which, see Hay 2004 and 2006). Especially significant, here, is themantraand, indeed, the realityof labour market flexibility. This, of course, issomething of a boon when times are good, demand is high and the economy isgrowing, for it allows demand to be matched by capacity, generating additionalemployment and preventing overheating. Yet, by the same token,whendemand fallsit iseasier inaflexible labourmarket to layoff thosewhose labour isno longerrequired.In effect, labourmarket flexibility stretches peak-to-trough variations in growth ratesand levels of employment.As the spectre of recession loomed, thatwas something theUKeconomycouldwellhavedonewithout.Forat thepointatwhich theservice sectorcontracts in response to falling demand, a series of self-reinforcing dynamics areunleashedas those laid off fail to keep upwith theirmortgage repayments, cut backtheir consumption to the bare essentials and, in the process, contribute further bothto the shortfall of demand in the economy and to a falling housing market.

This is 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 con-sumer confidence and confidence in service-sector and manufacturing profitabilityare so staggeringly low. This is the context, I would suggest, in which we mustlocate the move that I detect towards a covert re-politicisation of monetary policyin the UK (for a more explicitly political reading of the same shift, see Watson 2009,in this issue). But to understand this, it is necessary to consider the role played byinterest rates in the generation, sustenance and, indeed, unravelling of the longhousing bubble that the UK has enjoyed since the mid-1990s.

Here, again, the comparison with the Irish case is particularly instructive. Thegeneral conditions that made possible the steep rise in house prices, and thedebt-financed consumer spending boom that this facilitated, are highly conservedbetween 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

472 COLIN HAY


set by the growth of liquidity produced by the combination of the liberalisation ofworld financial markets and the move, led by the anglophone liberal marketeconomies, to deregulated domestic credit markets. As described above, this hasundoubtedly contributed to lower interest rates throughout the advanced liberaleconomies as well as improving the access of consumers to credit (especially, thatsecured against property).

But, as for the Irish case, these are by no means the only relevant factors. A seriesof rather more domestic drivers has also played a significant role. First, by com-mitting itself in opposition to the outgoing Conservative administrations ratherrestricted public expenditure commitments in 1997, the incoming Blair govern-ment found itself with an initially quite sizeable budget surplus for the duration ofits first term in office. This allowed it to repay a significant proportion of nationaldebt which both facilitated interest rate reductions and, perhaps more significantly,reduced inflationary expectations while increasing the sensitivity of demand inthe economy to interest rate variations (see also Watson 2000). In effect, it mademodest inflationary pressures easier to manage without significant increases ininterest rates. Rather serendipitously, this served to establish the conditions for aperiod of strong and non-inflationary growth combined with historically low andstable interest rates.

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

The Covert Re-politicisation of Monetary Policyin the UKIn December 2003, ostensibly so as to facilitate any subsequent decision to join theSingle European Currency, the government revised the Bank of Englands remit,

Figure 8: UK Service, Manufacturing and Consumer Confidence (200008)

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Service Manufacturing Consumer

Source: HM Treasury Pocket Databank (July 2008); BCC Quarterly Economic Survey

Note: For services and manufacturing, confidence in sector profitability



specifically its target for inflation (King 2004). In so doing, it switched from asymmetrical inflation target of 21/2 per cent for retail price index excluding mort-gage interest payments (RPIX) inflation to a symmetrical target of 2 per cent for CPIinflation (in fact, the EUs Harmonised Index of Consumer Prices, HICP). This wentlargely unnoticed and is scarcely commented upon in the existing literature (theexception is Watson 2008b).

But in the context of the present discussion it is highly significant, for the CPI, ofcourse, excludes mortgage interest repayments. In effect, the chancellor wasinstructing the Governor of the Bank of England and the MPC to ignore house priceinflation in determining UK interest rates; and he chose to do so at quite anopportune moment. For, as Figure 9 shows, fuelled by the developing housingbubble, the retail price index and the consumer price index were, at the time,diverging rapidly.

This might be seen as the first step in the covert re-politicisation of monetary policyin the UK, for it was an unapologetically political intervention by the chancellor andone which it is difficult not to see as motivated less by preparation for possibleEurozone entry than by a desire to keep interest rates down at a time when theformer inflation target was consistently being exceeded. That was certainly itseffect: interest rates in the UK from 2004 onwards have, one can only surmise, beenconsistently lower than they would otherwise have beencontributing, quitesignificantly, to the sustenance of the house price bubble from which the govern-ment benefited considerably until its implosion in 2007. This would seem toconfirm the impression of a government acting on and characterised not by time-inconsistent inflationary preferences so much as by sectorally differentiated infla-tionary preferences: a case of retail inflation bad, house price inflation good.

Figure 9: UK Inflation and Interest Rates, 200008

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retail price index consumer price index

interest rates mortgage rates

Note: Official bank rate (200608); Repo rate (200005)

Source: Bank of England

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Yet there is a second, more recent and arguably more significant, episode that mightalso be seen as evidence for the covert re-politicisation thesis. Here it is importantto consider in some detail the Bank of Englands management of inflationarypressures since the second quarter of 2006. The contrast with the ECB is both starkand interesting. For, as we saw when considering the Irish case, the ECB hascontinued to exhibit quite hawkish tendencies with respect to the management ofEurozone inflation, raising interest rates frequently and consistently since 2006 ascommodity, fuel and energy prices have risen. But the performance of the Bank ofEngland has been very different.

In the second half of 2006 and the first half of 2007, the Bank of England did indeedput up interest ratesno fewer than five times. And, judging by the subsequentmovement in the consumer price index, it did so with some success. The CPI fellfrom 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 earlierpeak (requiring the Governor of the Bank to write to the chancellor), no equivalentaction was taken. Indeed, quite the opposite. During the final quarter of 2007 andthe first two quarters of 2008 interest rates fell three times, despite considerableevidence of growingindeed, if anything, acceleratinginflationary 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 themonetary 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 offree-fall from the consequences of its own mandate. The Bank, it seems, unlike itsECB counterpart, came to share in the governments disaggregated view of infla-tionary pressures. And, in so far as this was the case, monetary policy in the UK hadbeen re-politicised, albeit in a rather covert way. The MPC, it seems, had chosen totear up its own remit and to adopt, instead, one driven solely by the governmentsunderstandable desire to secure once again conditions conducive to house priceinflation.

Conclusion: Dancing on the Edge of the PrecipiceThe UK and Irish housing bubbles are, at the time of writing, still in the processof imploding; and it is, of course, important not to jump too immediately toconclusions about the long-term consequences of processes as they still unfold.Nonetheless, a comparative analysis of the determinants, sustenance and broadermacroeconomic consequences of these ultimately unsustainable housing booms isilluminating in a number of respects. In particular, it points to the specificity of thefactors that have contributed to a shared trajectory of sustained house price infla-tion followed by rapid deflation (see also Leyshon and French 2009, in this issue).Both economies have increasingly come to rely upon personal debt-financedconsumer-led economic growth which has in turn depended upon equity release,easy access to credit and, in turn, low interest rates. Yet the specific constellation ofdomestic and, indeed, regional factors contributing to low and stable interest ratesis different in each case; as, of course, is the institutional context in which thebursting of the bubble has played out.



In the Irish case there is absolutely no prospect of a rapid resumption in house priceinflation arising from an accommodating monetary stance from the ECB. Monetarypolicy remains, and is likely to continue to remain, both doggedly hawkish in theface of inflationary pressures (as and when they resume) and resolutely depoliti-cised. But this may well be no bad thing for the Irish economy. For, althoughEurozone interest rates rose in the first half of 2008, they were still low by historicalIrish standards. Moreover, the strengthening of the euro to which the ECBsmonetary stance has undoubtedly contributed helped to hold down commodity,energy and fuel prices relative to many of Irelands competitors. Finally, as I havesought to demonstrate, though a significant contributor to Irish growth in recentyears, the housing market and the equity release that it has allowed are better seenas catalysts to growth rather than key determinants of growth per se. Unlike theUK, it is plausible to think that the Irish economy can grow in the absence ofre-establishing the conditions of house price inflation.3

The UK context is rather different and the prognosis potentially rather morealarming. Here, it seems, much was invested in the capacity of the Bank ofEnglandpursuing what can surely only be seen as a covertly re-politicised mon-etary policy in flagrant violation of its official mandateto cushion the impact ofstagflationary pressures on the housing market. This was always risky and there isabsolutely no evidence to suggest that demand in the UK housing market held upany better than it might otherwise have done so by virtue of the Banks turn to afar more accommodating monetary stance.

Of course, now that the recession has fully taken hold, inflation is no longer theproblem. But there are reasons for thinking that it is likely to re-emerge as aproblem 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 pitchingthe economy back into recession.

So what is it that makes the return of inflation so likely at the point at which growthin the world economy resumes? In short, a factor alluded to earlier: the almostunprecedented volatility injected into world oil prices by their increasingly specu-lative character. Oil prices are, of course, remarkably low at present, and it is therapid fall that brought this about that is largely responsible for stagflation in Britaingiving way to recession without any intervening interest rate rises. This hascertainly helped the Bank, which must have feared having to return to a morehawkish disposition had continued stagflation precipitated a major run on thecurrency.

But the point is that it may also serve to trap the UK economy in recession. For, asand when growth returns to the world economy, oil prices will surely rise, and ina highly speculative and accordingly volatile world energy market, this rise is likelyto be precipitous. The result, merely exacerbated by the weakness of sterling, isalmost inevitably an inflationary spike and a fresh headache for the MonetaryPolicy 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 linkbetween house price inflation and growth in the UK economy since the early 1990s(Case et al. 2005), as well as the sensitivity of the housing market to interest rates,this is almost bound to push the economy back into recession. Yet deferring interest

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rate rises and cushioning the housing market against exogenous inflation merelyrisks a further run on the currency, necessitating the more brutal return to ahawkish disposition at a later date. Such a run on the currency would, of course,only exacerbate further the inflationary pressures arising from the escalating costsof imported commodities, energy and fuel.

Painted in these rather bleak and admittedly broad brush strokes, it is increasinglydifficult to see how, in the absence of a new growth model for the UK economy,future inflation can now be controlled without pushing the economy into reces-sion. From the final quarter of 2007 through the first two quarters of 2008, theBank simply deferred the problem of dealing with inflation, and it is easy to seewhy. But the problem is likely to return. Growth in the UK is now perilously closelybound up with the availability of credit and the release of equity and both ofthese are now highly sensitive to interest rate variations. This makes the covertre-politicisation of monetary policy in the UK that we have seen in recent yearsentirely understandable, but it does not make it any less risky. We have, it seems,been dancing on the edge of a precipiceand the music has not yet stopped.

About the Author

Colin Hay, Department of Politics, University of Sheffield, Elmfield, Northumberland Road,Sheffield S10 2TU, UK, email: [email protected]

NotesAn earlier version of this article was presented at the Warwick conference on The Political Economy ofthe Sub-prime Crisis, 1819 September 2008. I am extremely grateful to participants for their helpful andencouraging comments and suggestions and to Paul Lewis, Ed Page and Matthew Watson for variousconversations about the re-politicisation of monetary policy in the UK.

1. The figure is, however, rather higherat close to 16 per centin the more volatile and more inflatedDublin market.

2. 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) theactual volume and value of housing market transactions. They nonetheless provide the best availableguide to the level of housing market activity over time.

3. The problem, of course, is that the euro has appreciated significantly against the currencies ofIrelands 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-drivengrowth dynamic are both in crisis. It is, nonetheless, far better placed to benefit from a resumption ofgrowth in the world economy than is the UK economy.

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