The calm before the fall

There have always been two schools of thought about the track of this particular crisis in the British economy. Firstly that the dramatic contraction in spending power would lead to price deflation- that the reduction in spending power would lead to a nominal fall in prices. The second was that the crisis would make money worth much less: that inflation would take a hold. Of the two, the policy makers fear deflation much more, because it is much harder to combat once it takes a hold- as the state of health of the Japanese economy has shown. Furthermore, inflation gradually reduces debt burdens, instead of increasing them- and the government has taken on a gigantic level of debt.

From the point of view of the consumer, though, inflation is quite bad news- essentially it reduces the value of holding money. This is why the inflation bears have become very strong gold-bugs, since gold typically holds its value when fiat money is being debased by inflation.

After the shocking absence of measures, in the PBR last week, to tackle the huge government deficit, perhaps we should not be surprised to see that inflation has indeed tracked up to 1.9%. The result may, however, be somewhat paradoxical and the root lies in the UK housing market. The fall in interest rates to historic lows has enabled some consumers to de-leverage, i.e. to pay back, their personal debts, but by contrast the mortgage debt market has actually recovered rapidly. We have seen increases in house prices, despite the generally poor economic outlook. To a degree, this was rational, since with the fear of deflation being so strong, it seemed that low interest rates would persist for some years. Yet it fails to take account of what is happening in the rest of the credit market.

The commercial property market in the UK is in a deep crisis: over 85% of loans granted over the past five years are in technical default. This could be simply that the value of a property has fallen below the stipulated loan to value ratio, but it clearly also includes large numbers of loans that are actually insolvent. We don't know how big a number these insolvencies may be, because the banks have taken steps - by stand-still agreements and so on- to ensure that there is not a flood of panic sellers which could undermine the whole market. We do know, however, that it was the commercial property book that destroyed HBOS. The numbers involved are therefore in the hundreds of billions of Pounds.

In the meantime, banks have been happy to lend to residential property, since they know that borrowers are highly motivated to keep paying- otherwise they lose their houses. With interest rates low, it seemed safe to maintain the stretched leverage ratios: lending five times a couple's joint earnings, for example.

However, if inflation is going to track up, interest rates will have to rise. Certainly the spike in Sterling this morning shows that the market is thinking about the prospect of higher interest rates in the UK.

Consumers in the UK have been pretty insulated from the global crisis- as long as you were in employment, low interest rates were actually making you better off. Now, it is clear that the crisis is set to move into a new phase which will substantially impact on British living standards. We already know that public sector employment is going to fall in line with some aggressive government spending cuts. Unemployment is set to rise sharply partly as a result. We already know that taxes in the UK will have to rise sharply. We already know that large numbers of high-earning foreigners are set to relocate from London in response to taxation and regulatory pressures. Now it seems that we will see a rising interest rate environment.

All of this is exceptionally negative for UK property prices. As it stands, UK property market is the most expensive market in Europe. In terms of price per square metre, London prime residential is nearly twice the comparable level for Paris and three times the level of Berlin. Yet the British economy remains in recession, while the Eurozone economies are generally recovering. This premium remains, despite the fall in the value of Sterling. Yet the supports for house prices are rotting: higher interest rates, higher unemployment, dramatic government cuts that -at best-will most likely keep the UK in a lower growth path; all seem set to create problems in the residential sector and underline the problems of the Banking sector as it still struggles to deal with the drastic weakness of the commercial property market.

The fact is that all of these policies: tax raises, expenditure cuts, and higher interest rates are necessary policy responses- but their combined impact could still be highly deflationary- at least for property prices. The distortion of the British economy by the overheated property market has been a long term problem. Now the situation is beginning to deteriorate- and that really will hurt the pockets of every property owner in the country.

The government may be trying to replay the 1970s, when high inflation reduced debt levels and made people feel richer as their houses went from being worth a few thousand Pounds to tens of thousands of Pounds- even if, in real terms, they rose much more slowly if at all. It may get 1990s Japan, when nominal prices fell.

In any event, either the price of Sterling or the price of property is going to fall dramatically. For which ever government emerges in 2010, it is political poison either way.