Comment, Economics

The Fallacy of Booming UK House Prices

Booming UK house prices don’t benefit anyone except moneylenders and property speculators – it’s time the great British homeowner woke up and realised they’ve been swindled.

In the United Kingdom, house prices, and property ownership are a national obsession. Say the words, “We’re Renting” in polite society and people look at you strangely; as if you’re ‘two sandwiches short of a picnic’. They simply cannot understand why anyone wouldn’t ‘own’ their own home.

Of course the word ‘own’ is an interesting one. Many home ‘owners’ are no such thing, owning but a small fraction of the ‘value’ of their houses. The rest is ‘owned’ by the bank. But even that is a misnomer. The money in the bank’s ‘loan’ was actually created when the loan was given, and collateralised against the value of the property or something else of value. Those with little equity in their homes, those with large outstanding mortgage repayments are not so much ‘homeowners’ as they are ‘leveraged asset speculators’. Leverage comes courtesy of brand new credit money pumped into the economy, or more precisely into the housing market, so another ‘homeowner’ further up the chain can cash in their chips having made a profit.

Unlimited Debt Cash at Zero Cost

The bank is unconstrained in the amount of loans it can issue. It really can lend as much as it wants to. The old fashioned “Mary Poppins” notion of a bank acting as an intermediary between a saver and a borrower is no longer the case. Banks actually create money when they lend it ‘electronically’ to individuals. They aren’t printing paper notes (under the 1844 bank charter act, that is illegal), but you can go to the cashpoint and convert your bank loan into cash to spend into the economy, so as far as anybody is concerned, it is as good as cash.

A banking licence gives banks the power to create as much money as they want, and it should come at no surprise that they create a lot of it, and lend it into the property market, hence house price inflation. People think that house prices are due to a shortage of housing stock. This is false, the main cause of high house prices is the unlimited credit available for mortgage lending into property. If credit wasn’t available, prices would stay much lower.

Banks ostensibly take risk when ‘extending credit’ to customers. When they lend, they have a liability on their balance sheet. Credit-worthy people pay off their loans with interest and the banks takes the interest payments as business cash flow. Some of this interest payment money goes to pay those members of the public who have deposited their money in the banks, but these deposits are dwarfed by the banks’ loans, so it is an equally tiny amount that gets transferred to them; banks are actually no longer interested in savers’ deposits.

When I say the banks take the risk of lending money, I am of course talking about the ideal scenario of a free market economy, which is not the economy the UK is currently enjoying. In the UK system, we have a system of crony capitalism, full of subsidies, handouts and privileges for a few (usually large) businesses.

UK Economy = Crony Capitalism

In a truly free market economy, if a business acts irresponsibly, it can expect to suffer the financial consequences. If it over stretches itself, it is over leveraged and becomes insolvent, and is declared bankrupt (bank-rupture).

In the UK & USA, recklessly managed technically insolvent banks were saved by government subsidies in 2008/9. This was a major error on the part of the Governments involved and highlighted how much the political parties pander to their funders in finance.

Given the chance, free market capitalism clears out the weak, unsuccessful models and replaces them with newer, better systems. Yet in London, mere months after multi-billion pound taxpayer bailouts, zombie banks were once more paying million pound bonuses to the very same morons who had overseen the financial system meltdown the first time around. This is crony (protectionist) capitalism at work. What we need is a free market.

That house prices keep on rising is a national belief. I might even go so far as to call it the new British religion, such is its power and widespread appeal. It’s hardly surprising. It has always been thus. It started when the USA left the gold standard and the big dollar fiat money experiment started, not just in the USA but in the other nations which had up to that point pegged their currencies to the gold backed dollar. No longer could a nation ask for gold in exchange for its US dollars.

Fiat Money

Fiat money systems don’t tend to last very long. Governments’ desire to print as much money as they see fit means that rampant inflation usually follows soon after their introduction. Once it starts, inflation is hard to stop as currencies enter a downward spiral of decreasing value from which they cannot escape. People anticipate prices rising and spend their money even faster, which brings about more inflation.

Paul Volcker, chairman of the federal reserve under presidents Jimmy Carter and then Ronald Reagan wanted to ensure that inflation didn’t get a foothold on the dollar, so he increased interest rates to a whopping 20%. Interest rates have been coming down ever since to the point that they are now effectively zero, and as they have come down, the cash available in the system has increased.

Under our current system, money is debt, and for there to be money in the economy, someone needs to have gone into debt. The ‘debt paradox’, is where people feel that paying off their debts is good for the economy, when in fact it means that money disappears from the economy, is symptomatic of debt based money systems, and is what drives our boom and bust economic cycles.

As credit expands, the money supply increases, but as debt outweighs cash in the economy, new loans are required to service the interest payments on the existing debt. When the fresh lending stops, people start to default on their debt repayments, as the interest payments have to come from somewhere and they cannot be paid by the productive economy (GDP). As more and more people default on their loans, even more money disappears from the economy, leading to a financial collapse, or a recession.

We are currently at the end of a fiat money experiment, which has lasted far longer than anyone might have reasonably expected. America, unlike the UK, has driven their economic growth with production and with innovation, principally technology and computing, and so has something sitting behind its wall of paper money, and so dollars still has some perceived value in the eyes of those who hold them.

If you hold a fiat currency note, you are holding a piece of paper backed by the nation which issues it; the USA is dominant in technology (computing), trading oil and other commodities priced in dollars, and war. So the dollar holds its value in spite of the fed’s money printing escapades (so called Quantitative Easing) because of the U.S. Economy which backs it up.

QE and Market Bubbles

Most of this QE money in both the US and UK has gone straight into the financial system. It was designed to encourage banks to lend more, by giving the banks more cash reserves on which to base their consumer and small business lending, and therefore to get more money back into the economy.

What has happened in practice is that banks have done what they saw as the best use of the money; they have lent it into property and formed another asset bubble, and they have invested money in the markets; stocks, bonds, derivates etc, very little of which affect the everyman on the street, and formed another bubble there also.

The UK economy has seen its fair share of money printing. As I write this, the general election is less than one month away, the UK is in recession, and yet the FTSE100 is close to breaking through the 7000 mark! An all time high. It seems strange that house prices are rising, stock markets are rising while salaries are stagnant or falling in real terms. What’s going on?

When more money goes into a particular asset or commodity, its price goes up. If more people buy dollars, their price increases as their perceived value increases. What has caused the property market and the stock market to rise, is an influx of new cash. It’s simply more debt, borrowed at preferential interest rates which have been falling year on year from 19% in 1968 to virtually zero at the moment. The same situation which caused the last financial collapse is about to cause the next. As long as we maintain debt based money systems, we will suffer financial booms and the busts which inevitably follow.

The Debt Money Paradox

Debt based money systems are interesting and frequently misunderstood. When cash is freely available, and in the case of a fiat money system banks can issue as much debt money as they see fit, the only thing which limits the bank’s lending is their borrower’s ability to repay. If they lend to someone who cannot repay, the borrower eventually defaults, the bank loses its income stream (cash flow) and the liability on the bank’s P&L must be filled or the bank is declared insolvent.

When interest rates are high, money is expensive to borrow and therefore the debt repayments comprise a greater proportion of loan repayments. Compound interest does its work, and time cannot help to make the debt  more affordable; you cannot make a big loan look any better over 25 years when the interest rates are high.

In an economy with high interest rates, say 15%, a mortgage borrower can afford to borrow much less money than if the interest rates were 2.5%. In real terms, the value of the property is much the same as it was before; it is a house which is ageing and falling apart, requiring repairs and investment to maintain its condition. What has increased is its ‘price’. The value of the money used to buy it will have changed. Money has value (is relatively scarce) when interest rates are high, but as interest rates fall, fiat currency becomes abundant, and as money is just a means of exchange, meant to represent the economic activity,  the value of it falls (inflation) and the prices of things bought with it go up. Buying a house is a hedge against inflation in fiat currency, nothing more, because that is where most of the newly created money has gone. So the way to look at it is this: People who bought houses early have not cashed in on a good investment, it’s more than individual who didn’t buy houses, have seen the value of their money eroded by the inflation of the fiat money supply. When governments operate fiat money, buy property and other fixed rent seeking assets, they will always appreciate in value as the value of the currency falls away.

By way of comparison, let’s look at an example scenario: if someone can afford to spend £750 per month on their rent or mortgage. Let’s have a look at how much the individual can afford to borrow over 25 years at two interest rates: 2.5% and 9%.

  • At 2.5% the borrower can afford to borrow £167,500
  • At 9% the borrower can afford to borrow £89,500

Not only that, the 9% loan wouldn’t have been borrowed over 25 years as the total repayment is astonishingly high, they would more likely have spread their repayment over a shorter period. At 9%, £750 a month is best dealt as a £71,500 loan over 14 years.

Would you rather have more Debt or more Disposable Cash, given the Same House?

Here’s a question for you. Would you rather live in the same house and have £167,500 worth of debt, or £71,500 of debt? The interest rate and therefore how much you can afford to pay is what sets house prices. When all is said and done these ‘investments’ aren’t cash generating businesses, they’re the same piles of bricks and mortar, falling apart just the same, and requiring painting, fixing up, and having their boilers fixed, and plumbing unblocked. The yield is mostly derived from appreciation in their value (depreciation of the currency).

Ah, but you’re not taking into account supply and demand!

It may seem so, but really supply and demand doesn’t really come into house prices as much as supply and demand of credit. What matters most is the notion of rising market prices, the herd mentality, and unlimited credit from high street banks to keep things ticking along. There are far more properties than there are people who want to live in them (do you know anyone living on the streets due to a lack of houses?).

What sets house prices is banks’ ability to create money (which is unlimited) and people’s ability to pay off the loan (which is limited by their salary and falling interest rates increasing the amount they can borrow). If you don’t believe me, the government’s help to buy scheme proves my point. The ‘Help to Buy’ scheme is designed to give first time buyers (the sub prime bracket who can’t afford to get a mortgage), enough capital to keep the whole ‘property market’ charade going a bit longer. At least until the 2015 general election has passed, then some other hair-brained scheme will be introduced.

This gradual lowering of interest rates which has occurred as the fiat money system has been unwinding, helps to spread a loan amount over a longer repayment period, and hence to increase the total amount of debt in circulation. This additional debt is required to pay off the interest on the debt which went before. And so on and so on.

If the salary of the mortgage borrower had increased, the amount of money they might be prepared to borrow could also increase. But when we have stagnating salaries, and house prices rise, we must assume this is due to some other factor (perhaps willingness to pay over the odds in perception of a rising market, or the desire to pay more money in the same scenario to live in a bigger house).

The houses are the same as they were before. The money created by banks only inflates the money supply reducing money’s value which is the same as blowing up prices, and as the amount of household income is fixed, the more money flows in interest payments to the banks to service these loans, the less is available to be spent into the real economy. In this sense, debt (and in a broader sense banking and finance) acts like a tax, removing cash which would otherwise be spent or invested in productive economy.

Without unlimited credit, houses (the same houses) would be cheaper to buy, money would be more valuable, households would have more disposable income, and the economy would be in better shape due to the increased cashflow. Money is debt and must be repaid with interest. The only free lunch is being collected by the banks when they fabricate this debt by typing numbers into a computer screen and collect interest payments on it. For a full disclosure of the situation, check out Michael Hudson’s book: The Bubble and Beyond.

Debt Deflation

What we see when credit bubbles collapse, is the reverse of inflation. When money enters a market, prices go up (the value of money, the most liquid form of value, goes down). But when debt collapses (and remember it wasn’t ever really there to start with, so when you default on your debt, or pay it off, the money disappears from the economy) the opposite happens. Less cash for the same assets, goods and services means prices go down, which is to say the value of cash goes up. It’s worth holding cash when a credit bubble collapses.

Despite what central bankers, financiers and hedge fund managers would have you believe, economics is actually pretty simple, when you want it to be. The ability to create credit at will adds no value to anything, because money represents an exchange of value, and prices will adjust based upon supply and demand of both assets and the means to purchase them. It makes bankers rich because they get to take a fee for making the money in the first place, and see the benefit of the value of the newly created money before its inflationary effect has occurred; by the time it filters down to the man on the street, the value of money has adjusted (decreased) to reflect the increased money in circulation, because money is representative of economy. The guy who spent it first got the benefit.

Who Benefits from High House Prices?

So who does benefit from booming UK house prices? If you consider the ‘housing market’ and view houses as you might view any commodity, those who buy low and sell high will gain from rising prices. Those who actually live in houses, buying larger and larger homes as their incomes allow and always upgrading to a larger property, will never benefit from rising prices. Neither will those who are coming to the age where they want to buy a home and have a family. These are the new mugs at the bottom of the UK housing pyramid scheme, and their cash is pocketed by the snakes further up the property ‘ladder’.

Those who speculate in property; those who buy-to-let and sell when asset values increase will also benefit. The government seems to encourage property ‘investment’, but as the UK economy is built on a housing bubble, this is not surprising. Those who create the money (the banks and building societies) also prosper from the interest payments on the significant loans they have created and lent into property. This should be viewed as a tax from productive economy towards the financial sector which it serves, rather than any productive wealth to be counted in GDP figures.

Credit Cycles

The credit cycle starts with a high interest rate, giving the impression of a currency with value, people buy into dollar based investments for the interest produced on their capital. Any debt based system requires that the debt money supply gradually increases over time, and as debt expands so must the value of money fall . Eventually (as we are seeing now) we may even encounter negative interest rates before the fiat money experiment finally dies a death.

What happened in Paul Volcker’s interest rate hike was an increased perception of the value of the dollar. This is why the federal reserve note has lasted as long as it has. But this experiment is coming to an end, and as the interest rates have fallen, as money has become cheaper to borrow, the amount of dollars flowing in both the US economy and further abroad has increased.

So why hasn’t inflation caught up? Many of these dollars (and remember, the dollar is still the world’s reserve currency) are sitting out there in the world doing very little. Much as a gold bar is seen as a store of value, so paper dollars are seen as a safe investment in other countries with less scrupulous, government issued currencies (Argentina, Zimbabwe, Romania).

If these dollars flooded into the market place, just as if all the diamonds in existence were released into the marketplace, their value would plummet. It’s simple supply and demand economics; buy dollars they become scarce and the price rises, sell dollars (exchange them for something else) and they become more plentiful and their value falls. A falling dollar value encourages further exit from the dollar and a further fall in its value. Once this starts nothing can stop the currency’s demise.

Hold Cash

As I have said, what we will see in the medium term is deflation. There is a fascinating interview with Paul Hodges about baby boomers and what he calls ‘The Great Unwinding’ in China, have a look at the interview on the Moneyweek website. Hodges believes that baby boomer led demand caused an economic boom which is now coming to an end, and as they stop spending money and save for their retirements (and we tend to be more prudent when we estimate how long we will live), their spending will decrease. So prices will fall to reflect the increased competition for less money being spent in the economy.

As the banks go ‘pop’ one by one, their credit will become worthless, and unless you are holding cash, nobody is going to want to know. Your debit card may work, assuming your bank hasn’t gone under. But it’s worth holding some paper cash for the intermediate period when the government turns on the real printing presses and we revert to a paper cash system to restore some trust in our money supply.

When is it Time to Buy a House?

What am I waiting for? I think what I’m expecting to see in the near future is government forced to raise the interest rates to protect the value of the currency. If Mark Carney doesn’t raise interest rates at the right time, the pound will start its inevitable decline and people will look elsewhere for a stable valued currency. Then, and only then will prices start to fall. As interest rates rise, debts will fall, people will default on their mortgages as they get stretched on their repayments. When is it time to buy a house? When prices are reasonable, that’s when.

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