Ever more dependent on the property bubble

I met up with a banker friend and relative of mine last Friday.  I take him seriously because, back in 2007, he was suggesting that he and I write a book together on the coming collapse of the global banking system.  I didn't - but it did.

This is what he said last week.  If you put bankers in a room trading bonds, and pay them bonuses to encourage them, they will carry on doing it until everything explodes.

This is horribly true.  It is one of the side-effects of bonuses of all kinds, and targets too.  They encourage people to leave their brains and consciences elsewhere.

The tragedy is that, five years on - and despite all the debate, heart-searching and tentative reforms - I am far from sure that the system is any more secure than it was before.

It is more secure against precisely the failures we had then.  Nobody is going to explode the world with subprime mortgage bonds.  But, as we know, history rarely repeats itself precisely.

This is important now and especially for the coalition.  On the face of it, the economy is racing ahead, the jobless totals are falling like a stone, Ed Balls is falling into line on the deficit.  But could the whole thing unravel again, just as before - but this time far more destructively?

We still have those trading floors full of traders lobotomised by bonuses.

We still have banks which are, terrifyingly, too big to fail.

But most of all, we still have a financial system that remains destructively geared to a continuing property bubble.

There are three elements to this, and we need to think about this in the UK particularly, because we are more enslaved to rising property values than almost anywhere else.  Here they are:

1.  Interest rates rise. Last week, unemployment dipped worryingly close to the level where the Bank of England said they would raise interest rates.  They have spun that one differently now, but sometime - probably within the next twelve months - interest rates are going to rise to a more normal level again.  That will mean a huge rise in government debt repayments, but - most important - it will be catastrophic for everyone who bought homes in the last five years in the way they seem to be encouraged to do: with interest rates right up against what they can afford.  It seems likely that property prices will then begin to slide as repossessions begin.

2.  The mortgage market.  When that happens, you have to ask what will happen to all those bonds backed by UK mortgages.  See for example the 2012 story about JP Morgan Chase, which has bet themselves on the safety of UK property prices - and, at that stage, owned 45 per cent of all the UK mortgage-backed bonds which had been put on the market in the previous two and a half years.  By 2012, their CIO outfit owned $100bn of mortgage-backed bonds of the kind that caused all the trouble last time.  They did so on the grounds that UK property was safer than US property...

3.  The money supply.  Politicians are a conservative lot in the UK, and they don't know much about where money comes from.  They rarely understand that about 60 per cent of the money in circulation was created in the form of mortgages (we hardly create any of our money the old-fashioned way any more, as non-interest bearing notes and coins).  If mortgages slow down, so does the money supply.  If the property market shifts on its axis, then the money supply suddenly dries up,

The terrible irony of this is that, despite that, we desperately need property to get less expensive - slowly.

Otherwise there is no way our children will be able to afford homes, or rent them, without selling their souls to financial services for a quarter of a century's indentured servitude.  More on that in my book Broke: How to Survive the Middle Class Crisis.

But two interim conclusions.

First, it is ridiculous that the financial system relies on these profitable peculiarities.  We badly need to modernise it, and to give it a fundamental re-think - if we don't want to repeat 2008 every generation or so, and probably more often.  The Australian government has launched a timid inquiry into the financial system, and we need to do the same - with a bit more oompf.

Second, the irony is that the wave of financial regulation in recent years has not tackled the underlying fissures (the ridiculously complicated capital requirements for banks, for example) - but has still managed to apply onerous new requirements to hamstring the small banks, which we rely on to do the basic work of deposit taking and loans.  See fascinating article by former US regulator here.

We have, in short, been going in precisely the wrong direction - undermining the most effective and useful banks but leaving the dodgy causes of the last crisis untouched.