There is a real danger that, for the third time in a generation, the housing market will complete a full cycle of boom and bust. Little appears to have been learnt from the past. As in the bubble of the 1980s, the orthodox view is that there is little the government can or should do to intervene. But inaction now threatens to undermine the government's hard-won reputation for maintaining economic stability.
Mervyn King, governor-designate of the Bank of England, acknowledges that recent house price inflation is both unsustainable and dangerous. The average house price to earnings ratio is now over 5.5, an all-time high. He has reason to be concerned. Indeed, he has warned that a sharp correction in house prices could well lead to a reduction in consumer spending, and so to widespread recession.
Moreover, collapsing asset values could bring into question the stability of lending institutions which have lent substantially against assets at inflated values. Standard & Poor's has warned that British banks are operating at worryingly high risk levels, comparable to those of Portugal and Panama.
The Bank may express concern but is powerless to act through monetary policy: the housing market demands an interest rate increase; the depressed traded sector of the economy, a cut.
The government, for its part, is showing no inclination to get involved. One reason is the soothing message from mortgage lenders that the boom is gently coming to an end. They may be right. But the mortgage lending business has a strong vested interest in talking up a 'soft landing'. Others, by contrast, suggest that panic and greed, allied with significant speculative demand, could further fuel the recent mania. It seems implausible that prices will gently stabilise over many years until earnings catch up; there is a greater danger they will crash as they did in 1973 and 1989.
So what can be done? Taxes are a blunt instrument. The loss of mortgage tax relief has, in practice, made little difference; when nominal interest rates are low the loss of tax relief costs the mortgage payer less. Stamp Duty can be varied by region to reflect market pressures but is a tax on transactions rather than ownership and depresses supply as much as demand.
A better approach for the longer term would be to tax site values to penalise the hoarding of land by developers and so increase supply. Planning complexities, however, mean this does not offer a realistic hope of influencing the market in the short term.
If action is to be taken quickly, the authorities will need to act directly on mortgage credit. An area that has not yet been properly explored is the use of prudential regulation to support macro-economic policy.
One idea would involve using capital requirements to moderate excessive and risky mortgage lending. There is no practical or ideological problem with this approach, since banks are already governed by international (Basle) rules for capital adequacy. The requirements could be refined to create a more sensitive system for aligning mortgage lenders' capital requirements to their lending practices and to the market, including regional variations within the UK. The Basle rules already allow the flexibility to make this possible and the FSA has powers it could use to ensure that non-UK lenders are not able to exercise a competitive advantage over domestic lenders.
Another solution could be to follow the Hong Kong model of acting on the average loan-to-value ratios of individual mortgage lenders. This would rein in the more aggressive lenders, whose activities arguably contribute disproportionately to market overheating.
In both cases there would need to be an analytical basis for intervention. The Bank's monetary policy committee, or even a separate asset valuation committee, could study trends in asset prices and establish reasonable ranges beyond which warnings, and then intervention, would be called for.
These solutions would need to be explored further at a technical level and discussed with the industry. But the real challenge is to the government. It is clear from speeches made by some members of the MPC that they are waiting for a political lead. If the government wants to maintain financial stability, it will have to do better than shrug its shoulders helplessly in the face of a looming crisis.
Vincent Cable is the Liberal Democrat shadow secretary of state for trade and industry.