UK house prices appear to have defied economic gravity over the past year. The lockdowns triggered by the pandemic led to a 10% fall in GDP, the largest fall in 300 years, since the Great Frost of 1709. Yet the latest data shows house prices have grown at the fastest annual rate – 13.4% – in 17 years. Are we in the midst of another housing bubble? An optimistic scenario is that the current boom is driven by the unusual circumstances of the pandemic rather than more systemic problems. Spending more time at home has led many homeowners to desire more space and a better environment. They have used the record buildup of household savings, amassed during the lockdowns and supported by the government’s furlough scheme, to buy larger homes or move out of cities (property prices outside cities have increased by 14% compared with 7% within them). The introduction of the stamp duty holiday by the government further ramped up the demand for such purchases. The phasing out of this subsidy at the end of June may help explain the most recent upturn in growth rates as people scramble to complete purchases. Once it ends, prices will probably flatten or fall for a few months; but it will be a soft landing as recent price rises reflect the ongoing structural changes to our working habits and desire for increased living space. A more pessimistic scenario is that the end of the stamp duty holiday will puncture a huge mortgage credit-driven housing bubble that will ripple through the financial system and damage the nascent Covid recovery. Mortgage credit has grown at record rates, expanding from -£280m in April 2020 as the first lockdown kicked in, to its highest ever rate of £11bn by March this year. The ultra-low interest rates and expanded quantitative easing programme of the Bank of England has also fuelled this credit binge. But how much harm will the bursting of this bubble do? In the short term, the wider risk to the economy at the aggregate level from a fall in house prices looks less severe than in 2008. Household debt (including consumer debt) is lower relative to incomes and so are interest rates on that debt. Alongside the savings that have been built up, this means that falls in people’s housing wealth should have less of a negative impact on consumer spending. Banks are also much better capitalised than they were in 2007, meaning a fall in the value of housing – which they hold as collateral against their mortgage loans – will be less likely to impact on their lending activity. But in the medium term, the risks could be more severe. Most obviously, rising inflation could lead to the Bank of England raising interest rates. The Bank has tried to calm such fears, arguing the recent surge in consumer prices was “transitory” – the result of the unusually rapid recovery in economic activity that has followed the reopening of the economy – and that as a result it has no plans to raise rates. There is certainly a case for “wait-and-see”, given the third Covid wave that is now washing across the country and the proposed end of the furlough scheme in September. But it is possible to imagine scenarios whereby inflation becomes more sustained, in particular if it continues to rise in economies such as the US and eurozone, with which the UK has close trading links, and if oil prices keep rising as global demand for energy or travel rebounds – or if the economy suffers ongoing shortages of labour due to Brexit-related issues that drive up wages. That would put the Bank in a difficult position, since although average household debt-to-income ratios have fallen since the 2007-08 crisis, its distribution across different socioeconomic groups is far from equal. There is a “long tail” of low-income households with high levels of debt – including unsecured debt – for whom even small increases in interest rates could make a material difference to their disposable income and spending power. The Financial Conduct Authority estimated that a quarter of all adults in the UK have low financial resilience, defined as having “little capacity to withstand financial shocks”. These groups are also more at risk from job losses with the end of the furlough scheme. The government’s promise of a state guarantee of mortgages worth 95% of a property on homes worth up to £600,000 will increase the size of this vulnerable group. Furthermore, the Bank’s own research suggests small rises in interest rates could contribute to falling house prices as property suddenly becomes less attractive to investors compared with safer assets like government bonds. Thus, while a return of interest rates to a historical norm of 4-5% seems highly unlikely, a rise to 2% is more feasible but could still have damaging impacts on the economy, weakening consumer confidence at a time when the government may be trying to reduce spending or increase taxation due to worries about the public deficit. This raises a broader issue. Whatever the idiosyncrasies of the pandemic, how did we end up with a situation where small rises in interest rates – a key tool of monetary policy – could raise such serious concerns for the macroeconomy? The UK has been wedded for decades to a household debt-led growth model, whereby ever-rising house prices driven by evermore bank credit support consumption via wealth effects and home equity withdrawal. Real estate is also the key form of collateral for the banking system, meaning house prices also impact directly on the ability of businesses to access credit. For a while, this form of “residential capitalism” can support consumption even when incomes stagnate. But it is economically inefficient and drives inequality and financial instability. Those who already own property gain the most while non-owners see their wealth decline and have to take on ever larger and longer mortgages to get on the housing ladder, suppressing their consumption. Since lower-income groups spend more of every additional pound of income, this can have deleterious economy-wide impacts. High levels of household debt coupled with house price crashes are associated with deep and long recessions. This model also drives highly damaging boom-bust cycles and mediates against long-term business investment and productivity growth. Why invest in new products or services when you can get a higher return on property? The pandemic has amplified these dynamics, but ultimately they are underlying flaws in our economy that require structural change. We need much higher taxes on capital gains on property to reduce speculative demand, stronger not weaker mortgage regulation, a more secure and better quality rental sector and a major public housing programme. Equally importantly, the UK requires a more aggressive, Biden-style public investment programme in good quality, well-paying public sector jobs in areas such as care and green infrastructure to raise incomes and make homes more affordable without requiring a crash in prices that could send the economy into a downward tailspin. Such a programme may also generate some inflationary pressure in the short-term. But in the long-term we need higher incomes, lower house prices and less household debt. Josh Ryan-Collins is head of finance and macroeconomics at University College London’s Institute for Innovation and Public Purpose