(updated June 09) In 2008 and early 2009, the pound was weak because

• UK interest rates fell from 5% to 0.5%
• UK entered deep recession. The reliance on the finance sector meant the UK was hit hard.
• The UK was quick to pursue a policy of quantitative easing (increasing money supply) this has potential to cause inflation and devalue the exchange rate. (money supply and exchange rates)
  
• High levels of government borrowing and the potential inflationary nature of this borrowing - especially if government monetise debt. (why high debt affects exchange rate)
  
• The Pound was overvalued by early 2008 as the UK experienced relatively high interest rates and a long period of growth

However, in recent months, the pound has strengthened. This is not because of a turn around in the UK economy, but a realisation that other EU countries and the US face similar, if not more serious problems.

For example, the German economy has suffered much more than expected because of a strong Euro, and collapsing export demand.

Although the UK economy still faces great uncertainty there are tentative signs of recovery. The Housing market looks more settled than in the depths of the 2008 slump, other areas of the economy are showing tentative signs of recovery. Also the quick fix of low interest rates and quantiative easing have helped boost chances of economic growth and inflation. If inflation does return to the UK, then interest rates will rise making the Pound more attractive.

The outlook for the Pound looks uncertain. A strong low inflationary recovery would help the pound maintain it's strength, but at the moment a strong recovery is very unlikely. I expect any recovery to be quite weak and the high levels of debt will keep foreign investors nervous of investing in the UK.

At the moment, the biggest factor in favour of Pound Sterling is the fact our competitors are facing a similar economic downturn and economic problems.

Related

• Run on the Pound - what's the panic? written end of 2008, arguing the Pound's weakness was overdone,
• Factors affecting Pound and Euro

The outlook for the dollar looks uncertain. There are certain factors which have caused many to fear a sharp decline in the value of the dollar. Dollar bears point to factors such as:

Rising National Debt

US National debt has risen from 41% of GDP in 2008 to an expected 81% in 2018. Part of this rise in government borrowing reflects the cyclical downturn and the effect on tax receipts. But, the debt also reflects a structural deficit aggravated by an ageing population and health care commitments.

A rise in national debt doesn't have to cause inflation and a depreciation in the Dollar.

(There are many examples of countries with larger national debts who haven't experienced inflation. In recent years one could look at the examples of Japan, Belgium and Canada. These countries have all had national debt of over 100% without causing any significant inflation. Japan's debt has now exceeded 200% of GDP)

However, the US Treasury purchase of dollar bills to finance the deficit is putting downward pressure on the dollar. And many are fearful future rises in government borrowing will just be monetised causing the dollar to devalue. It is this monetisation of the national debt which is putting most downward pressure on the dollar at the moment.

Hyperinflation

There are some analysts who see the increase in money supply and purchase of treasury bills as evidence we will see inflation in the future. This inflation will reduce the value of the dollar. However,

• This link is not as clear cut as some suggest - money supply and inflation


• Also, current inflation trends in the US are very low. In fact consumer prices are actually falling causing deflation to be a bigger worry at the moment.


• Interestingly in the great depression many feared inflation as a reason for the government not to spend more. Yet, the great depression led to a prolonged period of deflation

Interest Rates
The depth of the recession means that, according to the Taylor rule, the ideal US interest rate would be around -5%. This of course is not possible, but, it suggests 0% interest rates could be maintained for a longer time.

On the Positive side there are a few factors which could strengthen the dollar in future months.

Economic recovery. A panel of US economists tentatively suggest the US economy could recover by the end of 2009 and enjoy positive economic growth in 2010. This may lead to interest rates rising from rock bottom and if the US led a global economic recovery, the dollar would likely benefit.

Lower current account deficit. The current recession has gone some way to reduce the US current account deficit and reduce the trade imbalances which made the dollar susceptible to devaluation.

The dollar will always be shaky whilst the US treasury are purchasing Treasury bills to increase the money supply. But, the feared hyperinflation and collapse of the dollar does not look likely at the moment. There is still a reasonable chance the US economy could recover soon with only moderate / normal inflation rates. If this scenario did occur, the dollar could start to look attractive once more.

I rarely venture into politics. I'm too lazy to visit the polling booths so I get a postal vote delivered. The ballot arrived yesterday and the list for the European Parliament reminded me of a scene from Monty Python and the Life of Brian (People's Front of Judea scene). We have the UK Independence Party, The English Democrats, the UK First party, BNP, the No2EU, LibertasEU, Socialist Labour Party (similar to NO2EU party - left wing anti EU), there was even some joker standing for the Roman party e.t.c. There were more, but I can't remember them.

Anyway the economics of voting, is an example of the free rider problem. Why should I spend 10 minutes researching all the different parties and what they stand for when my vote isn't going to make a difference anyway. There is a temptation not to vote but free rider on the efforts of those who do go to the polls.

You could argue voting gives a sense of satisfaction in that you get to choose for the party you think is best.

£1.50 Icecube trays and £175bn annual Government Debt

On another related point it is interesting to see how much media coverage has been dominated by MP's expenses. It seems that government borrowing requirements of £175bn are too vast to comprehend so we'd rather concentrate on MPs who claim duck houses and horse manure on expenses. MP expenses are only a tiny fraction of government spending, but things like horse manure and Icecube trays are easier to relate to than abstract sums.

I recenlty wrote a piece whether MPs should be paid more?

Maybe someone should try to work out the volume of horse manure that would be needed to equal the value of £175bn. That may help people to understand the volume of government borrowing for this year.

What Does 1 Trillion look Like?

UK National debt is heading towards £600bn at the moment

Since March the US Federal Reserver has been buying US Treasuries by effectively creating money. The aim of this unorthodox monetary policy is:

1. Reduce yield (interest rate) on government bonds. The lower interest rates may encourage banks to lend rather than hold US treasuries. Also lower interest rates also help the government reduce the cost of servicing the debt.
2. Provide Monetary stimulus. By buying US treasury bonds from banks, banks will see an increase in the money supply and in theory will lend to private business and consumers. With a money multiplier this could be quite a large monetary stimulus. Because of the scale of the recession many fear deflation. Therefore increasing the money supply helps to prevent deflation becoming a problem.
   

Problems of Buying US Treasuries.

Inflation. Creating money to buy US treasuries has the capacity to cause inflation. At the present time the policy is not causing inflation because the falling velocity of circulation means that the increase in the money stock is not currently inflationary. However, in the future, the increased money stock has the capacity to cause significant inflation For more details see: Money Supply US

Foreigners Increasingly Nervous of Holding US debt. 23% of US government debt is held by China and Japan. The US need to raise another $2 tn for this fiscal year. They will be hoping foreigners keep buying US debt. But with the policy of increasing money supply, there is risk of devaluing dollar through inflation. Therefore, buying US debt could see a fall in the value for Chinese and Japanese investors. Recently both China and Japan have become nervous over the scale of US quantitative easing. (see: China warns US)

There is no sign of foreign investors wanting to dump dollar treasuries. It is not in the interest of China and Japanese investors to see a sharp devaluation in the dollar. But, the world's appetite for buying bonds is quickly falling.

see also: quantitative easing Policy in US

Many have been told dire stories of German hyperinflation in the 1920s causing economic upheaval, the rise of Hitler e.t.c. Because of events such as this and in Zimbabwe, there is a strong assumption that inflation is always and everywhere a serious economic problem.

Low inflation (of around 2% ) is indeed the primary economic target of all major economies. Everyone assumes inflation is bad, but, how really damaging is it if inflation rises above the inflation target?

Let us assume that inflation was to rise above 2% closer to 6 or 7% what would be the economic consequences?

Potential Costs of Inflation

Inflation reduces value of savings. High inflation reduces the value of money. Therefore people who keep cash under the bed will see their savings decline. But, who actually keeps money under the bed? If interest rates are higher than inflation then the real value of money will be maintained. Inflation of 7% and interest rates of 9%, is much better than the current situation of inflation 2.9% and interest rates of 0.5%. (which is a negative real interest rate). It is not the inflation rate that determines real value of savings but the real interest rate.

Inflation makes people worse off. Higher prices increase the cost of living. Again the key issue is whether nominal wages keep up with rising price level. As long as real wages remain positive people will not be worse off. All state benefits are index linked meaning that higher inflation will lead to bigger rises in benefits.

International competitiveness. A higher UK inflation rate causes UK goods to become uncompetitive. However, the inflation will also cause a depreciation in the value of pound restoring the competitiveness of exports.

Confusion and Uncertainty It is said high inflation rates create greater uncertainty and confusion leading to lower levels of investment. Alot depends on whether the inflation is anticipated or unanticipated. If inflation is anticipated the impact on uncertainty is much less.

Menu costs. Higher inflation rates mean firms will have to readjust prices more frequently. But, with modern technology it is easier to do.

The Spiral Effect. The big fear of inflation is that a moderate rise in inflation rates causes inflation to inexorably spiral upwards. If we allow inflation to rise a little, before we know it we are facing a real problem with inflation in 3 digits. In practise it is hard to control inflation once it starts to get out of hand. Therefore, its best to keep it low


Conclusion.

Targeting low inflation does make sense. By targeting low inflation we can provide a framework for sustainable and stable economic growth. It helps avoid boom and bust cycles which are very damaging.

However, maybe some Central Banks (in particular the ECB) could loosen up a little and not feel so guilty if inflation slightly overshoots the target. Many years ago, Norman Lamont told us 'unemployment is a price well worth paying for lower inflation' but, maybe this assumption is misplaced and not true. Whilst inflation does have costs, there are potentially much bigger costs of dogmatically targeting low inflation, especially in the current climate.

Also another lesson of this recession is that targeting low inflation is insufficient to maintain macroeconomic stability. The low inflation of the early 2000s seems to have given us a false impression of economic stability.

More on

• Costs of inflation

Readers Question: I have always wondered why economic growth and inflation are seen together, one seems to be good, the other not... I understand it theoretically... But still the question stays in my mind... You know we are keen on economic growth... But then there comes inflation, I just don't get it. Which one is the cause of the other, and is there a certain inflation rate that helps the economy to grow?

Economic growth can cause inflation. If the economy expands faster than the underlying trend rate of growth it generally means demand is rising faster than supply. Firms are facing supply constraints so they tend to put up prices. Also as labour shortages occur because of fast growth, wages tend to rise causing inflationary pressure.

Economic growth doesn't have to cause inflation. If aggregate demand increases at the same rate as aggregate supply, it means the economic growth will be sustainable and non-inflationary. For example, between 1993-2007, economic growth in the UK was averaging around 2.5%, this caused inflation to remain low.

Does Inflation Affect Growth?

It is assumed that a low but postive inflation rate helps economic growth.
Firstly, if inflation is negative (deflation) then this fall in prices is likely to lead to lower growth or negative growth. Falling prices reduce growth because:

• Falling prices means consumers delay purchasing items, leading to lower consumer spending
• Falling prices increases the real burden of debt reducing disposable income and reducing consumer confidence
• Falling prices mean real interest rates will be too high.

If inflation is 'too high' then it is argued it may create uncertainty and lack of confidence causing lower growth rates.

Boom and Bust Cycles.

The main problem of inflation is that if growth is too fast we get high inflation. And this boom in the economy tends to be unsustainable. After the boom and high inflation we get an economic downturn. A good example is the Lawson boom and 1991 recession.

When Low Inflation is Insufficient

It was hoped that maintaining a low inflation rate of around government's target of 2% would avoid future booms and busts. But, the problem is that despite low inflation we had a credit and asset price bubble. When the credit and housing bubble burst in 2007-08 this caused a severe recession. This shows that targeting inflation can be insufficient.

How would the UK economy have fared if we had been in the Euro? Could we have avoided the current crisis or would it have been worse?

Firstly, if we had been in the Euro, UK interest rates would have been set by the ECB according to what was best for the 16 Eurozone members. It is possible if the UK had been in the Euro, the ECB would have pursued different interest policy, but I doubt it. With 16 members it is hard to set rates just to help one country.

Firstly, in the boom years, 2004-07 UK rates were higher than the ECB interest rates. If we had been in the Euro, we would have experienced lower interest rates during this period. ECB rates were 2% during 2004 and 2005. This could only have exaggerated the housing boom, encouraging even more to try and buy a house. House prices could have risen even further giving them further to fall when the market turned in 2007.

Secondly, after it become evident the UK was heading into a deep recession, UK rates fell much quicker than ECB rates. The cut in interest rates doesn't seem to have helped the UK economy that much. But, without the rapid rate cuts the UK recession would have been deeper.

Thirdly, in the Euro the UK would not have been able to pursue quantitative easing - increasing money supply to help avoid deflationary pressures.

Fourthly, we would have not benefited from a depreciation in the value of the Pound. This depreciation is helping to boost exports compared to Germany which is seeing a drastic fall in exports.

In many ways, this recession should have hit the UK the hardest in Europe.

• The UK had the greatest exposure to a failing financial sector
• The UK had one of the largest booms in house prices and the highest rate of homeownership
• The UK had one of the highest levels of consumer debt and lowest saving ratios.

However, the data from the first quarter of the Eurozone show a quartely fall of 2.5% for the Eurozone ( annual rate of -6.4%). The ECB commission predict a nearly 5.4% fall for Germany and 4% for the Eurozone in 2009. BBC link


Some issues like the rapid rise in UK public sector borrowing wouldn't really be affected by being in the Euro. The UK economy is far from showing signs of any real recovery, but, the combination of aggressive policy shifts does seem to have averted a catostrophic fall in UK output that could have occured without radical policies.

Looking at the Eurozone fails to inspire any confidence in recovery. The ECB seem to have an institutional and irrational fear of inflation which is misplaced in the greatest recession since the 1930s.

It may be the weakness of the Eurozone will cause the Euro to fall. And this combined with a global recovery could help pull out the eurozone economies out of the deepest recession in living memory. But, it is far from a foregone conclusion. Evidence suggest that GDP in the Eurozone is only 3% higher than in 2000. Already people are talking of a lost decade and if deflation sets in like in Japan it will only get worse.

The Taylor rule is a formula for setting interest rates depending on changes in the inflation rate and economic growth.

A simplified formula is: r = p + 0.5y + 0.5 (p - 2) + 2 (after Tobin, 1998)

• r = the short term interest rate in percentage terms per annum.
• p = the rate of inflation over the previous four quarters.
• y = the difference between real GDP from potential output.

• This assumes that target inflation is 2% and equilibrium real interest rate is 2%

Example of Taylor Rule:

• If inflation were to rise by 1%, the Taylor response would be to raise the interest rate by about 1.5%
• If GDP falls by 1% relative long run trend rate, then the Taylor response is to cut the interest rate by about 0.5%
• Basically, higher growth and inflationary pressures require higher interest rates to reduce economic activity. Lower growth and a fall in inflation require lower interest rates to boost spending.
  

Using this formula, it is clear that in the period 2002-04, the US Federal Reserve kept interest rates too low. These low interest rate were a key factor (though by no means the only cause) of a boom in credit and a boom in house prices.

Interest Rates Too Low in US Using Taylor Rule

The interesting thing is what the Taylor rule says about current interest rates. Since GDP in US has collapsed by - 4% (when growth trend is about 2%) it means that GDP is much lower than potential. Paul Krugman estimated that using the Taylor rule, the US should give a nominal interest rate of -7%. This indicates why the Federal Reserve are having to resort to quantitative easing. They can't cut interest rates below 0%, so they need to resort to unorthodox measures to boost the economy.

Taylor Rule and Suggested Interest Rate for US

• 
• Interest rates explained
  
• source of graphs - Urbanomics Taylor Rule
• Taylor Rule - Bized

Whilst there is still much debate about the likelyhood of deflation in the UK and US (see: inflation vs deflation) It is worth examining the impact of deflation in Japan. Japan has been experiencing deflation on and off since the 1990s and yesterday saw unwelcome statistics that showed a return of deflation to Japan (Official inflation rate -0.3%).

At first glance, falling prices appears to be a boon to consumers as goods and services become cheaper. But, combined with falling incomes and rising unemployment it creates a toxic mix of economic stagnation.

Problems of Deflation

Price Wars. To attract consumers, firms began price cuts that became increasingly aggressive, but, the price wars did little to boost overall spending, it only led to smaller profit margins and caused many firms to go under. The fall in output caused unemployment in Japan to rise from 2% to 5%. 5% may still seem low, but, this official figure ignored a lot of disguised unemployment such as early retirement or temporary work.

Paradox of Thrift. With the threat of unemployment, consumers sought to save and reduce their spending. The incentive to save is increased by falling prices. Falling prices means goods are cheaper in the future therefore people kept delaying purchases, espeically of big ticket items. The combined rise in savings reduces consumer spending. (the Japanese saving ratio did fall in this period, but, this was due to other factors such as an ageing population)

Rising Debt Burden. Deflation increases the real burden of debt. This caused problems for firms and consumers with large debts, discouraging investment and spending. Deflation in the UK and US would be even more damaging because consumers are more exposed to debt.

Difficulties in Dealing With Deflation

Zero Interest Rates. Even though Japan cut interest rates to 0%, deflation means the real interest rate remained high.

Fiscal Policy. Japan did try various measures of fiscal expansion such as government spending schemes. But, these were often inadequate. Unfortunately, Japan's economic crisis coincided with concerns over an ageing population and the impact on the government finances. Worried over the rising debt burden, the Government increased taxes in 1997 and promptly caused another recession. The recession led to further rises in government debt and Japanese debt now stands at close to 195% of GDP.

Difficulty in Creating Inflation.

We have got so used to worrying about inflation, it seems hard to believe that to create moderate inflation can actually be quite difficult. The Japanese Central Bank did introduce a limited form of quantitative easing, increasing the money supply by upto 12% a year but it struggled to gain normal inflationary pressures.

The recent economic recovery of Japan 05-07 was mainly export based. Thus when the global economy slowed down, Japanese GDP collapsed again leading to a further bout of deflation.

It seems deflation is an ill that persistently dogs the Japanese economy.

Deflation in Japan at BBC

The US Dollar is often viewed as a safe haven currency. It is still the world's reserve currency and the thinking is that if the dollar goes bust the rest of the world will be in an even worse situation.

Therefore, during the worst of the economic turmoil, the dollar remained relatively strong because investors preferred to have the security of US dollar assets (e.g. US Treasury bills) With the global economy reaching new lows, investors became nervous about any type of risk, therefore, the US dollar benefited.

With the sign of 'green shoots of recovery', markets are regaining a small appetite for risk and so are looking to diversify away from the dollar. Currencies like the Canadian Dollar and Australian dollar are likely to benefit from an economic recovery. This is because an economic recovery will cause commodity prices to rise from their current lows. In turn, higher commodity prices will help increase the value of Canadian and Australian exports making the currency stronger.

Therefore, the dollar has been weakening because investors are seeking to diversify away from just the security of dollar.

There are of course many other factors affecting the dollar. A US economic recovery may enable interest rates to rise, making it attractive to hold dollars.

On the other hand, many argue the green shoots of recovery are still very feeble and the optimism could be misplaced. With the unemployment on the rise, economic stagnation could persist.

In the longer term, the value of the dollar will depend on the effect of the government's growing budget deficit and policies of quantitative easing. Whilst deflation may be more likely than inflation in current climate, the increase in the money supply, leaves the potential for inflation and a develuaing dollar in the future. (potential of US dollar collapse)

Give Me a One Armed Economist - seems to be the theme of the week. This week, we have two economists highlighting opposite dangers - inflation and deflation.

• Paul Krugman writes convincingly on the dangers of deflation threatening the US economy. (article)
• On the same day, Alan Meltzer argues the Fed is ignoring the risk of Inflation. (article)

The interesting thing is both bring strong economic analysis to their differing opinions.

Paul Krugman points to the large spare capacity, debt deleveraging and falling nominal wages as powerful causes of deflation. He also makes the point that deflation and falling wages will be very harmful for a struggling economy. A cut in nominal wages is akin to rising interest rates on mortgage payments.

Alan Meltzer looks to other features of the economy. He sees

• large government borrowing
• Quantitative easing and growth of money supply.
• and a Fed seemingly ignoring risk of future inflation.

In reposte to this, Paul Krugman points out the experience of Japan who had high debt, growth in money supply, quantitative easing but no inflation


So which risk is greater?

I still feel it is the threat of deflation that poses the gravest risk to the economy. The scale of monetary and fiscal stimulus means it may be hard to overshoot the inflation target. But, overshooting an inflation target will be much less painful than a decade of economic stagnation.

And this is a lesson the ECB may need to learn pretty quick.(update, ECB yesterday cut rates to 1% and even made tentative moves towards quantitative easing) But, the ECB still lag behind US and UK in dealing with the threat posed by deflation.

Up until the 1970s, the European Union had very low rates of unemployment. It was even referred to as the 'European unemployment miracle' But, after the supply side shocks of the 1970s, unemployment rose and remained stubbornly high until the mid 1990s. Recent improvements in unemployment have been set back by the current recession which has caused unemployment to rise to 8.9% with forecasts for the rate to go above 10% soon.

Also it is worth pointing out Unemployment rates vary across the EU area. Spain has the highest rates, yet the Netherlands have quite low rates.

What is Cause of Unemployment in Europe?

High Unemployment Benefits. European states tend to have generous welfare benefits which decrease incentive to get a job. However, countries like the Netherlands have seen low unemployment rates despite similar benefit rates.

Labour Market Rigidities. European economies often have generous protection for workers. e.g. hard to hire and fire workers, maximum working week. Protection for trades unions. This gives protection for 'insiders' but not outsiders. It also could explain why European unemployment could be for a longer duration. Within the political systems there is often reluctance to reform labour market policies which protect certain workers at the expense of the unemployed. (Bean 1994)

Skills Based Changes. Factors such as globalisation and increased specialisation have led to rapid changes in demand for skilled workers. The consequence is that unskilled workers have found it more difficult to gain employment. (Lawrence 1994, Krugman 1995, Baldwin and Cain 1997)

Conservatism of ECB. The ECB has a strong reputation for keeping inflation low. The target of monetary policy is low inflation and arguably this holy grail of low inflation means they are willing to sacrifice growth and investment. It explains the contrast in response to the ECB and Bank of England to the current recession. (Theodore Peligidis 1998 link)

Rigidities in the Euro. The Euro prevents individual countries - cutting interest rates, devaluing currency to improve competitiveness and even places limits on fiscal policy. This has reduced the competitiveness of fringe Euro members such as Greece and Spain and explains some unemployment.

Unemployment is underestimated in the US. US unemployment rates are lower, but arguably there is a higher disguised rate of unemployment including low paid part time jobs.

Conclusion

The more you look into European unemployment the more you realise there is no simple answer. It is unsatisfactory to explain it all away with blaming labour market rigidities and generous welfare benefits. O.J.Blancard (2004) states "High social protection is not inconsistent with low unemployment. However, it must be provided efficiently."

It is also important to consider both demand and supply side policies. The scale of the German recession illustrate how the ECB's conservatism in Monetary policy could adversely affect unemployment in both the short term and longer term

Further Reading

• Causes of Unemployment
  
• Explaining European unemployment
• European Unemployment - myths and realities
  

Readers Question: What caused the carefree attitude of the American population that led to loose regulations on lending and the eventual collapse of our housing market–and why didn´t most major companies act on historical evidence from previous disasters?

Some ideas that Spring to Mind

Irrational Exuberance. The idea that people get caught up in bubbles and don't like to consider negative side of the story. For more: see: Irrational exuberance and the economics of herding

The End of The Business Cycle.

Francis Fukayama wrote a book in 1991 writing about the triumph of liberal democracy.( This optimistic view has been since questioned). But, in a similar vein analysts in the 2000s, were pointing to what they saw as the end of the business cycle. They pointed out that through the Federal's Reserves control of interest rates, they had managed to avoid boom and bust economic cycles. e.g. the 2001 recession was very short lived and, in the 2000s, inflation (a typical indicator of boom) was absent. Therefore, many felt if inflation is low then we can't be in a boom and so growth is sustainable. The problem was that the boom was building in asset prices and credit markets.

Paul Krugman made a memorable quote

“If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: it will be what [Alan] Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.” source: When Greenspan was nearly God

It reflected the strength people felt towards the power of the Federal Reserve in controlling the business cycle.

Passing of Responsibility.

• One issue that we pick up from the sub-prime crisis is that people were able to pass on ultimate responsibility.
• Homeowners were sold mortgages by mortgage salesmen. A homeowner may have presumed - well if a bank wants to lend me a mortgage then it must be OK. I mean a bank wouldn't lend me a mortgage if I had no chance of repaying it?
• But, the mortgage salesmen were paid on commission, so they had a vested interest to sell mortgages whether or not the homeowner could pay it back. However, they didn't have to worry about future repossessions. They were paid on commission.
• The mortgage companies weren't too worried because they could rebundle their mortgages to 'rocksolid' banks. They might have thought - If banks like the prestigious Lehman Brothers and HSBC are buying our mortgage bundles then we must be doing the right thing.
• Even the credit rating agencies were giving triple A rating to these bundles of mortgage debt.
• To summarise there was a sense of diminished responsibility. A feeling - the crowd can't be wrong. Because everyone else was going along with the new type of mortgages / lending e.t.c people felt - who am I to go against the wisdom of the crowd?
• In fact there were whistleblowers who claimed they warned their banks they were doing the wrong thing but were dismissed for raising warning signals. (e.g. HBOS executive Paul Moore claims he was sacked for acting as whistleblower) Link Guardian

Rationalisation of Irrationality

The human mind is good at rationalising a seemingly irrational concept. E.g. leading mortgage adviser in 2006 Why the Real Estate Boom will not bust (2006) - books they wish they hadn't written.

Government Support

The government sought to extend home ownership and encouraged government agencies Freddie Mac and Fannie Mae to underwrite many of the new homes being built.

Heads You Win Tails You Don't Lose

In the problem of bank bonuses, I mention how bank executives could gain bonuses for taking risky options, but, didn't lose out if their risk failed. Therefore the bonus culture encouraged risky decisions and a culture of short termism which ignored long term risk.

Lack of Education.

Even in banking industry there is little time spent analysing past crashes, the emphasis is how to make profits in the here and now.

See also:

• Why Roof Fell in on US Housing Market
• Who is to blame for financial crisis?
• Financial Crisis explained
  

"Give me a one armed economists" - Dwight D Eisenhower got so fed up with his economists giving him two sides of the argument he came up with this famous quote - referring to the idea that economists wouldn't be able to say but on the other hand...
With house prices some analysts have rock solid conviction that prices will drop another 30% or so. Yet, the case for a large drop may be less than apparent. This is the case for both sides.

Why House prices have further to Fall

Depth of Recession and rising unemployment. With unemployment rising at a record rate more homeowners are struggling to repay mortgages and face repossession. The unemployment rate is forecast to get worse over the next 12 months.

House price Income Ratio. According to the Nationwide building society the ratio between the house prices paid by first-time buyers and average incomes, peaked at 5.4 in 2007. This has since fallen to 4.1. But rather worryingly in the last property bust, the ratio fell to 2.1 in the mid 90s. For the house price to incomes ratio to fall to that level would either require a doubling of incomes (highly unlikely at moment) or 50% fall in house prices.

Mortgage Market still moribund. Despite minor flickers of hope in the mortgage sector. Mortgage approvals remain at rock bottom. With more bank losses still looming, there is going to be no quick return to easy lending. Banks are likely to remain cautious asking for large deposits which put off potential buyers.

Past Trends. Past trends suggest house prices could fall for 4 years. In the last house price crash house prices fell for nearly 5 years. There were the odd months where house prices rose, but, this did not change the underlying trend downwards. (historical house price trends)

Why House Prices may Rebound Soon

Affordability. When deciding whether to buy a house or not, most people look at monthly payments and effective affordability. This gives a more realistic assessment than house price to earnings. On this grounds, extra low interest rates are making buying a house more attractive than renting. Try using this mortgage calculator at the Times. If you assume 0% house price growth, interest rates of 4.5% and 3% increase in rents - most cases lead to substantial benefit to buying a house, especially in the longer term.

Banks regaining profitability. Despite rise in bad debts, banks such as the Abbey are reporting increased profitability. Abbey reported a 25% profit increase in the first 3 months of this year. António Horta-Osório, Abbey's chief executive, expected the UK's mortgage market to return to net lending.


More Buyers returning to market. Reports show more enquiries at estate agents. Though it is worth pointing out making an enquiry and getting a mortgage approved are different things.

Future shortages. The government are trying to build 240,000 houses a year to meet expected future demand. This year, that number could be as low as 110,000. It's a simple supply and demand equation. Lack of housing puts upward pressure on house prices.

Conclusion

House prices are being pulled in two ways. Given state of economy and fact house prices still look relatively expensive it seems likely house prices will continue to fall. But, with interest rates so low, the pervading British desire to own a house is being rekindled. Despite the difficulties of getting a mortgage maybe people will find a way to get back on the property ladder.