Investment unmasked as consumption as UK pops: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

LONDON (Reuters) - During the housing bubble a lot of people confused consumption with investment, a fact now becoming painfully obvious in Britain as prices fall and businesses suffer.

As in the United States, home owners helped inflate a wider bubble by ploughing money into housing-related consumption, from granite kitchen countertops to living room furniture to under floor heating. The illusion, or justification, was that this consumption, often financed via mortgage debt, was actually investment in a can't-miss real asset.

It wasn't, it's stopping and the impact on the economy will be considerable.

Think of it as the "Land of Leather Fallacy," after the British furniture retailer now coming to grief due to people no longer thinking that buying a lemon yellow L-shaped sofa will be repaid with a higher house price or is part of a viable buy-to-let retirement plan.

Now you may not have Land of Leather where you live, but if you live in one of the economies which has been in the grip of a property bubble you will have something similar: a barn like store on a busy road outside of town selling household durable goods.

Business, for these companies, has not been so good lately.

Land of Leather Holdings Plc LAN.L, whose shares have fallen to about 5 pence from 228 pence last August, has like many similar companies seen its sales plunge, in its case by 35 percent in the six weeks to June 6. This comes as housing transactions in Britain fall off a cliff, down 13 percent month-on-month in May. House prices were down 2.4 percent in May and 6.4 percent in a year, according to the Halifax index.

Don't get me wrong, I'm sure Land of Leather makes comfy sofas and in some ways what has happened is not their fault. But they were part of a huge misallocation of resources.

The unwinding of that, which is midway in the Unites States but just beginning in Britain, is going to be difficult, especially as central banks have little room to loosen rates due to rising inflation.

Shopping will give way to saving, and some consumption will rebalance to actual investment.

THE ILLUSION OF CONTROL

In fact, beyond durable goods, the bubble in housing changed common attitudes towards owning a house, persuading people to consume more housing by buying as much as they could afford or by buying more than one house.

And while that strategy works beautifully when prices are going up by three or four times the rate of general inflation, it feels much more like consumption -- sometimes at an astonishing cost -- when prices are flat or falling.

At that point the older person with a large house or someone with a vacation house can see very clearly that they are consuming housing rather than investing in it.

Ed Stansfield, an economist at Capital Economics in London, believes that considerable supply of housing may come onto the market as that psychology changes with falling prices.

"It gives you a very clear incentive to buy the biggest, most expensive place you can get your hands on when you believe in your heart of hearts it will rise by 10-15 percent a year, " he said. "That whole mentality has been applied to the property market. Once a change in expectations becomes embedded, a lot of speculative demand vanishes."

Because house prices were rising so rapidly, people became confused about what was cause and what was side-effect. Anything that was remotely housing-related was warmed by the glow of rising prices.

Wanting to believe that the rise in prices was fundamental, people ascribed the boom to things they were doing, like home improvement or decoration, rather than to too loose credit and unsustainable speculative investment.

"It's a classic example of the illusion of control," said James Montier, a strategist at Societe Generale in London and an authority on behavioral finance, the study of how emotion and thinking patterns influence economics and investment.

"We are obsessed with the idea that we can control situations where we have absolutely no control. We attribute all good outcomes to our own skill and bad outcomes are somebody else's fault."

Now of course some of the falloff in volume for housing related businesses is simply because transactions are lower, and when at last transactions pick up you would expect sales of furniture and the like to go up too.

But I would bet that the attitude towards that consumption becomes much more sober. In a falling market, the money that goes into housing-related consumption will fall and those sectors will take a very long time to recover.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: saft@thomsonreuters.com --

(Editing by Ruth Pitchford)