The end of a miracle in UK?

Axel Leijonhufvud, the Swedish-born economist, once made an insightful observation about inflation targeting. It worked better in practice than it did in theory, he said. I feel the same about the UK economy. Given what we have long known - about the country's relatively low productivity growth rate and the erosion of its scientific and engineering excellence - the British economy should clearly not have performed quite as well as it did for the past 15 years. Economic theory would suggest that this was not possible.

In the next few years, I expect the UK economic miracle to be exposed for what it was: an overlong joyride on the back of an overlong asset price bubble. The UK economy is about to undergo a downturn at least as large as that of the US - maybe even worse, because of an even more inflated housing market and because the financial sector constitutes a larger share of gross domestic product.

According to my calculations, UK residential property prices are about 30 per cent above their trend in real terms. If the trend has not changed in the past few years, that would suggest that inflation-adjusted prices could fall by up to 40 per cent from peak to trough.

Of course, it is possible that the trend has changed, that cool Britannia has attracted so many foreign buyers that the trend line may have shifted higher forever. But foreign buyers can leave just as quickly as they arrive and their presence is related to the health of the financial sector. My guess is that the half-century-old trend line is still approximately right.

Moreover, the trend is consistent with several other indicators, such as the ratio of house prices to rents achieved, which in the UK has recently been about two-thirds above its long-term average. Whatever explanations one might come up with in defence of higher house prices, they cannot conceivably explain why house prices should be out of line with rents forever.

A house price crash would take time to unfold. Assuming a constant inflation rate of 2 per cent a year, nominal house prices would have to go down by about an unprecedented 25 per cent if the decline stretched over six years. Remember: the first stages of a housing downturn consist of denial followed by anger. A fall in actual prices is a relatively late-stage phenomenon of a housing crash.

-Britain can no longer depend on being cool