George Osborne guides UK on unsustainable trajectory

Ask yourself this question: When have house prices in the UK ever been higher?

According to the Halifax House Price Index, the only time prices have been higher, as a multiple of average earnings, was just in the run up to the crash of 2007/8. And as you can see from the graph below, we are now on course reach or exceed those levels all over again.

So, why should this matter I hear you ask… Maybe house prices will simply flatten out, at some high level and we can just carry on with our great economic recovery… The problem is that a sizeable constituent of the demand for houses is precisely the perception that they are on a rising trajectory. When the trajectory is no longer expected to continue, the enthusiasm for new mortgages drops dramatically and you have a crash in house prices and consequently a crash in demand for new mortgages.

So why should a crash in mortgage demand matter? Surely housing will just be cheaper and we’ll all be happy? The problem is, that with our crazy fractional reserve monetary system, the amount of money in the economy is critically dependant on the amount of borrowing that goes on. So a slump in borrowing equals a slump in money. Economists and the media confusingly refer to this as a “credit crunch”, but it is more accurately described as a money crunch. Money, quite literally, starts disappearing. As Mervyn King said just after the crash “What the banking system has been doing is destroying money“. A shrinking money supply is painful for an economy, and George Osborne is setting us up for just that scenario.

There are ways out of this predicament. We don’t actually need rising house prices forever to maintain the money supply. We could actually have normalised interest rates, non-looney house prices and a stable money supply… we just have to fix our crazy monetary system and switch to something sane like full reserve banking as supported by the FT’s Martin Wolf.