Housing, consumer debt and the next financial crash

Last autumn this column predicted a financial crash that did not happen. Since then share prices have rallied and optimism about a recovery has grown. Yet curiously a quarter of newsletter commentators are still predicting a financial crash.

Some say very soon, others believe it will happen after George W. Bush is re-elected to the White House this fall. The reason is that interest rates will have to go up, sooner or later, and that will bring the whole financial house of cards crashing down.

In truth the longer low interest rates persist the worse a correction has to be. This has to be the case because low interest rates encourage people to borrow more and more, and the longer it goes on the more inclined they are to forget about tomorrow.

But tomorrow always comes. Debts have to be paid, and interest payments have to be met. Last year The Economist magazine caused a storm with an article pointing out just how overpriced housing was in a number of key global economies, and suggested that a correction was due.

The small uptick in UK interest rates appears to have already had that effect with house prices falling by 1.1% in December. But this is only the start of a rise in base rates from today's 3.75% to higher levels. The impact on housing prices in some markets will be unavoidable and obvious.

Consumers that see their spending power cut by higher mortgage rates will have to stop spending and that is bad for the real economy. They are also less likely to borrow more on credit cards or to take personal loans.

It is no secret that consumer spending is the motor that drives any modern economy. Lower spending means lower profits for companies, and the stock market will quickly price that anticipated change into share prices. It does this very quickly, sometimes in one day. It is called a stock market crash.

Now it would be churlish to hazard a guess as to when this will happen. It could be that the US economic recovery stalls more quickly than the present indicators suggest, or that in an election year the mood of public optimism may keep rolling for a while longer.

But this is a false recovery. The debts and overspending of the previous boom have not yet been expunged from the system. Stock prices have not yet touched anything near the undervaluation that they need to go to before a new bull market can begin. The dollar will go to a new low. It is just a matter of time.