Debtors (and banks?) ‘crucified’ on inflation cross

The FT reports today on a debate economists are having with the Bank of England (BoE). To summarise: the Bank of England does not seem bothered by falling house prices; economists are.

This is a very important debate for all those that have debts – because while house prices are falling, the debts on those houses loom larger for owners. According to the Office for National Statistics in May, unemployment is rising, and unemployment makes it hard, if not impossible, to pay off any kind of mortgage. This is the context in which the BoE is preparing to raise interest rates above the current 5% and appearing relaxed about falling house prices.

A lot of innocent borrowers are affected by the BoE’s policies and actions, and by its mandate from the Labour government. According to the Dept. of Communities and Local Government 14.6 million people in England own their own homes and 8.3 million have mortgages. The craze for buy-to-let mortgages means that some have more than one. Given that the average UK household is made up of 2.36 people this means about 19 million people in England alone are affected by changes in the cost of mortgages, i.e. rises in the rate of interest.

The Bank of England is obliged by a law drafted by the then Labour government’s Chancellor, the Rt. Hon. Gordon Brown MP, to fix interest rates at a level which keeps inflation within the government’s 2% target. In other words, Gordon Brown insisted that it was more important to target inflation, than to keep interest rates low. Now, because inflation is rising the government mandate means that the BoE must now allow interest rates to rise, to curb inflation, even though all debtors are already under terrific pressure from falling house prices and rises in fuel and food costs.

Peter Spencer, an economist with the influential Ernst and Young Item Club, has warned that consumers (most of whom are debtors) will be ‘crucified’ if the government continues to insist that the Bank of England defend an inflation target of 2%. For this to happen, the ‘committee of men’ (see blog below) at the BoE that set the rate of interest, will have to keep interest rates at 5%, or even raise them further.

So debtors are in for a hard-time. And if debtors are in for a hard time, so are their creditors – the banks. Prof. Nouriel Roubini argues that “47% of the assets of all major banks” are related to property. In the US, he argues, 67% of all assets of smaller banks are related to real estate. In the UK, one bank, Northern Rock has already gone belly-up and efffectively had to be nationalised by the government because it was too exposed to a property market – the sub-prime market – where debtors were defaulting. If more debtors default on their mortgage payments, Prof. Roubini believes that “the chances of hundreds of banks going belly up – starting with one that has already gone bust – the US’s biggest mortgage lender, Countrywide “- could thus cause “a systemic banking crisis“ (my italics). Because banks operate internationally, such a crisis would not be confined to the US.

A systemic banking crisis will not be a pretty sight. And once again, it will be politicians and central bankers, ‘guardians of the nation’s finances’ – who will have helped precipitate that crisis, because of their determination to make controlling inflation a priority over lowering interest rates.