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Article: Joining Euroland

A campaign to persuade us to adopt the Euro is likely to commence within just a few months. How might ditching sterling affect the UK house market?
This article first appeared in the spring 2005 edition of the UK Market Review.

Joining Euroland

[This article first appeared in the UK Market Review, spring 2005. The anticipated referendum on membership of the Euro was, of course, never held.]

There is an old joke in which an ambassador, on being asked by a journalist what he would like for Christmas, gives an avuncular response: “Oh, just a nice bottle of port and a good cigar.” This attempt at modesty appears a little lacking in vision when, in the subsequent newspaper article, it is set alongside the replies of other diplomats: “an end to child slavery,” “a solution to the Middle East crisis,” “a ban on manufacturing landmines.”

A similar situation faces those being asked – as we probably shall be – to debate the virtues of adopting the Euro as our national currency, especially in relation to the residential property market. The founders of the EU and its present-day enthusiasts talk of the sweep of history and of permanent peace. Detractors see only short-term costs and practical difficulties. The problem for the former camp is that, at the moment, short term benefits to the UK house market are hard to see. The core reason is simple: interest rates.

Stability in house prices rests upon a foundation of balanced inflation, earnings growth (including employment levels) and interest rates. Movement in any one of these will tilt house prices, as the market seeks equilibrium. Since 1993, inflation (RPI) has fluctuated little and averaged less than 3% pa. Over the same period, earnings have followed a similarly even track at just over 4% pa, with overall affordability boosted by reductions in unemployment (over two million, according to official figures, since 1996). The big change has been in base interest rates, which fell dramatically over the mid-90s to average approximately 5.6% since 1993 compared with 11.4% from 1981 to 1992. For most of us, mortgage costs were more than halved and this, coupled with earnings growth, is what led to the trebling of house prices. But when interest rates were increased by just 1.25% over 2003/04 – a change that would have added about 10% to our payments in the 1980s – it increased typical mortgage costs by over 30%. Unsurprisingly, everything started to slow down. We had become (and remain) so highly geared whilst at record-low interest rates that relatively tiny adjustments make a big difference. And if we enter Euroland at current levels, the adjustment will not be tiny. It will be a drop of 2.75% in the base rate, reducing the cost of most variable rate mortgages by about 50% overnight. Now for many, this would be welcome. But with borrowings already at record levels, a ‘turbo-charged’ housing boom would risk higher inflation and a reduction in real earnings, especially as the house market is a much less important factor in the still dominant French and German economies, where owner occupied homes make up just 56% and 43% respectively of the housing stock. (It is a common misconception, that the UK leads Europe in home ownership, as the panel above makes clear.)

There are strong arguments to suggest that, over longer periods, adopting the Euro would be good for economic stability especially if our leaders, if and when they are given a mandate to adopt the Euro, have the patience to wait for true economic convergence (one of the five key tests’). But at current interest rates it would, in the short term, increase house prices and debt in the UK housing market. It would also expose us to a greater risk of interest rate rises of a magnitude which, though quite normal from an historical perspective, would be enough to precipitate a market crash. A return, in other words, to ‘boom and bust’ and to all of the financial problems that go with it, none of which anyone wants.

Then again, to those who are old enough to remember the last war and its destruction of tens of thousands of houses along with their occupants, the odd recession in the house market might appear a trivial price. Especially if the benefit is permanent peace across 25 European states encompassing over 192 million homes.

Sources: CML, HM Treasury

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