The British Journal of

Politics and International Relations

doi: 10.1111/j.1467-856X.2009.00380.x

BJPIR: 2009 VOL 11, 461478

Good Inflation, Bad Inflation: The

Housing Boom, Economic Growth and
the Disaggregation of Inflationary
Preferences in the UK and Ireland
bjpi_380

461..478

Colin Hay
This article 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 that has 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 performancewith the shift to official measures of inflation that exclude mortgage
interest repayments and, in the UK at least, to the covert re-politicisation of monetary policy. It
concludes by suggesting that governments may well not have time-inconsistent inflationary preferences so much as sectorally specific inflationary preferences. This might be summarised in terms
of the aphorism: retail price inflation bad, house price inflation good.

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

crisis

The recent implosion of the house price bubble in the advanced liberal economies raises serious concerns about macroeconomic management, the counterinflationary preferences of public authorities in particular. Those concerns are
perhaps most acute in the anglophone liberal democracies, whose economies have
experienced both the largest house price increases and which now seem destined to
suffer the most spectacular downward recalibration in pricesand whose growth
strategy in recent years seems to have rested most heavily on consumption fuelled
by equity release in a rising housing market.
This article argues for the merits of a comparative approach to the inflation and
puncturing 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 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.
2009 The Author. Journal compilation 2009 Political Studies Association

462

COLIN HAY

The basic argument of the article is simply stated. For rather different reasons,
Ireland and the UK stumbled serendipitously upon consumer-led and private debtfinanced 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 toand to improve affordability withinthe housing market,
driving a developing house price bubble. Once established this was sustained, if not
perhaps actively nurtured, by interest rates that remained, by recent historical
standards, unprecedentedly low throughout the boom. Yet, as is now increasingly
acknowledged, 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 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 act
effectively as financial intermediaries, repackaging new loans as mortgage-backed
securities (MBSs) for institutional investors such as pension funds. The lions share
of their income is generated, not from the interest rate spread between deposits and
loans, but from transaction fees. Consequently, they are energetic and often highly
innovative in offering new mortgage instruments to potential borrowers, confident
in the knowledge that they can pass on any interest rate risk they might otherwise
bear to buyers of MBSs. In a rapidly growing housing market, they are also likely
to be a source of capital to fuel consumption for borrowers keen to release the
equity they have built up in their property. As Herman Schwartz suggests (2008,
263), 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.
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 have
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 now
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. As such, it is surely realistic to assume that they now perceive themselves to
have a considerable political (and electoral) stake in securing the conditions for a
rapid resumption in house price inflation (see also Crouch 2009, in this issue). 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 (MPC) of the Bank of England and its European Central Bank equivalent. It also suggests that we are likely to seeif we have not already begun to
seea 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 article that this is indeed the case. Moreover, and
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

GOOD INFLATION, BAD INFLATION

463

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

600000
500000
400000
300000
200000
100000
0
1990

1992

1994

1996

1998
Ireland

2000

2002

2004

2006

2008

Dublin

Source: Department of Environment, Heritage and Local Government

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 re-politicisation of monetary policy in the
UK that this suggests, it is important first to examine in some detail the anatomy of
the house price bubbles in the UK and Ireland in recent years. 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 honourif honour it
islies with Ireland, which experienced, between 1997 and 2005, a staggering 185
per 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 the
market in early 2006.
What this figure also shows is that, despite considerable concern about rising
inflation, falling growth and less favourable conditions for new borrowers following
the sub-prime crisis, average house prices in Ireland have thus far lost less than 8
per cent of their peak value.1 Put slightly differently, prices in the first quarter of
2008 were in fact rather higher than those in the first quarter of 2006, only six
months before the peak in the housing bubble. In explaining this, it is useful to look
at the more detailed and differentiated picture presented by Figure 2.
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
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

464

COLIN HAY

Figure 2: Irish House Price Inflation

60
40
20
0
2001

2002

2003

2004

2005

2006

2007

2008

-20
-40
% 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

between the present quarter and the equivalent quarter in the previous year. It
demonstrates a couple of important things. First, it shows just how staggering the
period of sustained house price inflation in Ireland waswith 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 house prices have 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 has fallen sharply (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 Irish
housing boom. In a sense this is alarming. For it suggests that house prices have a
long way still to fall. Put simply, we cannot gauge the likely impact of the credit
crunch and inflationary tendencies on house prices until such time as sellers adjust
their expectations to new housing market conditionsand an increase in the
volume of housing transactions will be the first sign that they have done so. It is
likely that this process of psychological adjustment will bring with it a significant 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 be
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

GOOD INFLATION, BAD INFLATION

465

Figure 3a: Irish Inflation, 19982007

a
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

Source: Irish Central Statistics Office

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 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 bubblesas institutional investors have flitted
from tech stocks to mortgage-backed securities and now into commodity and
energy markets (for an excellent discussion of both dynamics, see Blyth 2008). For
liberal market economies with highly securitised mortgage markets this has
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 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 major
trading 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 Eurozone
entry.
Or so one might think. The reality has, in fact, proved rather more complex than
such a simple assessment might imply. Here it is instructive to look at two rather
different graphs of inflation performance in recent years for the Irish economy. The
first, Figure 3a, shows Irish government official inflation data for the period 1998 to
2007in other words, the period before the impact of the credit crunch on the Irish
housing market.
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

466

COLIN HAY

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 have quite
consistently 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 they
have risen steadily since (at a time when the Irish growth rate has also risen 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 insufficient to control the Irish business cycleand this despite some evidence of business
cycle convergence with the Eurozone (Hay et al. 2008). Second, and more significantly, the graph also shows a substantial and growing disparity 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, more recently, a clear and ever-growing gap
has opened up between the CPI and the HICP.
What makes this particularly interesting is that the HICP is a measure of inflation
that excludes mortgage interest payments, household insurance premiums and
building materialsin 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 inflationindeed, it redefines inflation in such a way that
the 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 consistently been lower than those that would have been set by an independent Bank of
Ireland with an equivalent remitlower still than those that 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 suboptimal character for
the Irish economy of the ECBs interest rate settings and by the ECBs preference for
a 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 to
examine Figure 3b, which extends the time frame to include the bursting of the
house price bubble and shows, in addition to the CPI and HICP, the ECBs interest
rate settings over this period. Two features of this graph are particularly important
for the broad argument of this article. First, as might be expected from the preceding
discussion, as the housing market has slowedand, indeed, contractedthe CPI
and the HICP have converged. Nonetheless, both continue a steep upward trajectory seemingly unchecked by ECB interest rate settings. With Ireland experiencing
negative growth for the first time in three decades in the first quarter of 2008, this
is alarming indeedraising 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
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

GOOD INFLATION, BAD INFLATION

467

Figure 3b: Irish Inflation and Interest Rates, 200208

b
6.0
5.0
4.0
3.0
2.0
1.0
0.0
2002

2003

2004

2005

CPI

HICP

2006

2007

2008

ECB Base Rate

Source: Irish Central Statistics Office

experienceas we shall see presentlyand although insufficient to quell Irish

inflationary pressures, the ECB has been dogged and consistent in raising interest
rates as inflationary pressures have built, seemingly regardless of the consequences
for the housing market and for consumer-led 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 has 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.
The implications of this for the Irish economy are interesting. The Irish government
can expect no reduction in interest rates while the inflationary pressures associated
with rising fuel and commodity prices persist. And it seems, at present, reluctant to
use fiscal stimuli to inject demand into the housing market. This may make the
present Irish predicament sound 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 is it the most significant
determinant of Irelands growth trajectory in recent years. The Irish economy can
grow again in the absence of house price inflation. Second, the ECBs hawkishness
with respect to Eurozone inflation has 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 has undoubtedly helped to control inflation, since the price of
its imports from major non-euro trading partners has invariably fallen and it has
also served to cushion the burden of rising commodity and energy prices. 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 4.25 per cent. Indeed, with any historical perspective, interest rates below 5 per cent are low by Irish standards. As this suggests,
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

468

COLIN HAY

Figure 4: UK House Price Inflation, 19862008

30
25
20
15
10
5
0
-5
-10
-15
-20
-25
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

while any interest rate hike is likely to be unpalatable to 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.

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 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 it was 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. 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 points (198889, 199798, 200305, 200709), it is only twice in
the last 20 years (199094 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 prices 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
currently falling at a level unseen in the UK in the previous two decades.
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

GOOD INFLATION, BAD INFLATION

469

Figure 5: UK Housing Market Transactions (Volume and Value of Stamp Duty

Receipts)2
1500

value of transactions

190
170

1100

150
900

130

700

110
90

500

number of transactions

210
1300

70

300
2002

50
2003

2004

2005

2006

value of housing transactions

2007

2008

number of housing transactions

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

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 2008. What this shows,
particularly when considered alongside the previous graph, is that it is the volume
of housing market transactions that is hit first as housing conditions worsen. As
with the Irish case, it seems, house prices in the UK have proved downwardly
sticky, though there is perhaps greater evidence from the most recent UK data that,
despite still declining housing market activity, prices are now beginning to fall
precipitously. Until such time as sellers readjust their 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 fallbut they clearly have some
considerable distance still to travel.
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
credit-based consumption was, between 2004 and 2006, typically worth between 4
and 6 per cent of GDPor, 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 et al. 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
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

470

COLIN HAY

Figure 6: UK Lending Secured against Dwellings: 200209

2150

11000
1950

10000
9000

1750

8000

1550

7000

1350

6000

1150

5000
950

4000

750

3000
2000
2002

equity release (M)

house purchases and remortgaging (M)

12000

550
2003

2004

house purchases

2005

2006

2007

remortgaging

2008
equity release

Source: British Bankers Association Monthly Statistical Releases

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 19,400or 65 per cent of annual pre-tax
earningsin a 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 built 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. But, at a time of rapidly rising commodity and energy
prices, it is very likely to alter significantly their desire to extend further their
indebtednesscertainly to fund current consumption. But the point is that it is
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.
Yet this is not just a story of a lack of demand for additional lending. For had they
wanted to release equity, all the evidence suggests that they would have found it
increasingly difficult to do sowith 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 is both a supply-side and a
demand-side squeeze on debt-financed consumer spending in the UK todayand
neither component of the squeeze is likely to weaken any time soon. This is
demonstrated very clearly in Figure 6.
The graph shows the capital value of new lending in the UK secured against
property between 2002 and 2008 (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 wayallowing us, in particular, to
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

GOOD INFLATION, BAD INFLATION

471

Figure 7: The Composition of New Mortgage Lending in the UK (Percentage of

Total, by Number of New Loans)
55
50
45
40
35
30
25
20
2002

2003

2004

house purchases

2005

2006

remortgaging

2007

2008

equity release

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 lending secured in the UK against property was solely for the
release of equity. Moreover, at this time levels of equity release were the equivalent
of 2.5 per cent of GDPand, 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 and still ongoing. Levels of equity
release are now the equivalent of 0.5 per cent of GDP (0.8 per cent if we include
new unsecured loans) and their value continues to fall rapidly.
As this suggests, and as Figure 7 confirms, the composition of lending secured
against property in the UK has changed very significantly since the onset of the
credit crunch. The mortgage market is now dominated by remortgaging, with
the proportion of new lending accounted for by equity release and new house
purchases combined falling well below 50 per cent (whether gauged in terms of
volume or capital value of new loans secured). As this suggests, the throughput
from the housing market to consumption that sustained the UK economy throughout the 1990s and, indeed, until very recently has been severed. For an economy
that 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 now threatens to become a vicious circle. The fear must be that a
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

472

COLIN HAY

combination of largely exogenous inflationary factors and, again, largely exogenous

shocks to liquidity in the market for mortgage-backed securities will deplete the
equity homeowners had built up in their properties (as well as access to any equity
that 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 of
interest rate hikes to control inflation, this was always likely to reduce significantly
personal disposable income. The first casualty in such a context, inevitably, is
discretionarytypically, service-sectorconsumption. For an economy like the
UK, this is disastrous, in two respects in particular. First, as already noted, the
growth dynamic of the UK economy in recent years has been predicatedto an
extent probably unprecedented among other leading economieson 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 holdwith
disposable 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 literaturewhether academic or popular.
That is the profoundly pro-cyclical character of New Labours political economy (for
more details of which, see Hay 2004 and 2006). Especially significant, here, is the
mantraand, indeed, the realityof 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 overheating. 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 the spectre of 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
unleashedas those laid off fail to keep up with their mortgage repayments, cut back
their consumption to the bare essentials and, in the process, contribute further both
to 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 consumer confidence and confidence in service-sector and manufacturing profitability
are so staggeringly low. This is the context, I would suggest, in which we must
locate the move that I detect towards a covert re-politicisation of monetary policy
in 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 by
interest rates in the generation, sustenance and, indeed, unravelling of the long
housing bubble that the UK has enjoyed since the mid-1990s.
Here, again, the comparison with the Irish case is particularly instructive. The
general conditions that made possible the steep rise in house prices, and the
debt-financed consumer spending boom that 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
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

GOOD INFLATION, BAD INFLATION

473

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

60
40
20
0
2000
-20

2001

2002

2003

2004

2005

2006

2007

2008

2009

-40
-60
Service

Manufacturing

Consumer

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

set by the growth of liquidity produced by the combination of the liberalisation of

world financial markets and the move, led by the anglophone liberal market
economies, to deregulated domestic credit markets. As described above, this has
undoubtedly contributed to 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 has also played a significant role. First, by committing 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 while 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 Re-politicisation 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,
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

474

COLIN HAY

Figure 9: UK Inflation and Interest Rates, 200008

8
7
6
5
4
3
2
1
0
2000

2001

2002

2003

2004

2005

2006

2007

retail price index

consumer price index

interest rates

mortgage rates

2008

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

Source: Bank of England

specifically its target for inflation (King 2004). In so doing, it switched from a
symmetrical inflation target of 21/2 per cent for retail price index excluding mortgage interest payments (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.
This might be seen as the first step in the covert re-politicisation of monetary policy
in the UK, for it was an unapologetically political intervention by the chancellor and
one which it is difficult not to see as motivated less by preparation for possible
Eurozone entry 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, one can only surmise, been
consistently lower than they would otherwise have beencontributing, 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 on and characterised not by timeinconsistent inflationary preferences so much as by sectorally differentiated inflationary preferences: a case of retail inflation bad, house price inflation good.
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

GOOD INFLATION, BAD INFLATION

475

Yet there is a second, more recent and arguably more significant, episode that might
also be seen as evidence for the covert re-politicisation 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 has
continued to exhibit quite hawkish tendencies with respect to the management of
Eurozone inflation, raising interest rates frequently and consistently since 2006 as
commodity, fuel and energy prices have risen. But the performance of the Bank of
England has been very different.
In the second half of 2006 and the first half of 2007, the Bank of England did indeed
put up interest ratesno 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 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 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 re-politicised, 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 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 (see also Leyshon and French 2009, in this issue).
Both economies have increasingly come to rely upon personal debt-financed
consumer-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 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.
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

476

COLIN HAY

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 rose in the first half of 2008, they were still low by historical
Irish standards. Moreover, the strengthening of the euro to which the ECBs
monetary stance has undoubtedly contributed helped 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 are better seen
as catalysts to growth rather than key determinants 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.3
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
Englandpursuing what can surely only be seen as a covertly re-politicised monetary policy in flagrant violation of its official mandateto cushion the impact of
stagflationary pressures on the housing market. This was always risky and there is
absolutely no evidence to suggest that demand in the UK housing market held up
any better than it might otherwise have done so by virtue of the Banks turn to a
far more accommodating monetary stance.
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 a
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 precipitous. 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 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
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

GOOD INFLATION, BAD INFLATION

477

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,
future inflation can now be controlled without pushing the economy 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 rate variations. This makes the covert
re-politicisation 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 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: c.hay@sheffield.ac.uk

Notes
An earlier version of this article was presented at the Warwick conference on The Political Economy of
the Sub-prime Crisis, 1819 September 2008. I am 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 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 inflated
Dublin 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) 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.
3. 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 is the UK economy.

Bibliography
Blyth, M. (2008) The politics of compounding bubbles: The global housing bubble in comparative
perspective, Comparative European Politics, 6:3, 387406.
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, 161180.
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, 132.
Central Statistics Office (2007) Consumer Price Index: January 2007 (Dublin: CSO).
2009 The Author. Journal compilation 2009 Political Studies Association
BJPIR, 2009, 11(3)

478

COLIN HAY

Crouch, C. (2009) Privatised Keynesianism: An unacknowledged policy regime, British Journal of Politics
& International Relations, 11:3, 382399.
Finlayson, A. (2009) Financialisation, financial literacy and asset-based welfare, British Journal of Politics
& International Relations, 11:3, 400421.
Hay, C. (2004) Credibility, competitiveness and the business cycle in Third Way political economy, New
Political Economy, 7:1, 3957.
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), 251271.
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 &
International Relations, 8:1, 101121.
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), 182
203.
King, M. (2004) Speech to the Annual Birmingham Forward/CBI Business Luncheon, Villa Park,
Birmingham, 20 January.
Leyshon, A. and French, S. (2009) We all live in a Robbie Fowler house: The geographies of the buy
to let market in the UK, British Journal of Politics & International Relations, 11:3, 438460.
Schwartz, H. (2008) Housing, global finance and American hegemony: Building conservative politics one
brick at a time, Comparative European Politics, 6:3, 262284.
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,
237261.
Watson, M. (2000) The Political Discourse of Globalisation: Globalising Tendencies as Self-Induced External
Enforcement Mechanisms (University of Birminghamm, Ph.D. thesis, unpublished).
Watson, M. (2008a) Constituting monetary conservatives via the savings habit: New Labour and the
British housing market bubble, Comparative European Politics, 6:3, 285304.
Watson, M. (2008b) The split personality of prudence in the political economy of New Labour, Political
Quarterly, 79:4, 578589.
Watson, M. (2009) Headlong into the Polanyian dilemma: The impact of middle-class moral panic on the
British governments response to the sub-prime crisis, British Journal of Politics & International Relations,
11:3, 422437.
Wyss, D. (2007) The subprime market: Housing and debt, Standard and Poors Research, 15 March.

2009 The Author. Journal compilation 2009 Political Studies Association

BJPIR, 2009, 11(3)