The £50 billion bank bail-out

UK - London - The City: Bank of England and First World War Memorial, originally uploaded by wallyg.

The Bank of England's £50 billion bail out has been made to sound as if the tax payers will be protected from loss since the value of the mortgage debts will be discounted in the exchange for government bonds - the so-called haircut.

But the aim remains that of pumping more money into the banking system so that mortgage lending can get going again. But it is an excessive supply of money which has pumped up housing [housing land] prices in the first place. These prices need to be allowed to come down to realistic figures.

But what is a realistic figure? Something like the market rental value divided by the market rate of interest, expressed as a fraction.

Since market interest rates are around 6%, capital values should be about 17 times annual rentals. On that basis, a house let for say, £1500 a month should be worth about £310,000, but at the top of the market such a house would have been sold for about £380,000. This indicates that house prices need to fall by something like 20%.

All that the Bank of England is doing by making money available for lending is to keep the bubble pumped up for longer. But it is still bound to burst. Only, like a volcano that has not erupted for a very long time, the effects will now be much worse and the damage greater.

There are two likely events to follow. The first is inflation, probably at 1970s levels. The second will be recession. When the land market has progressed to such a stage of unreality, such a recession is inevitable. The bail-out is just putting off what is unavoidable.

With the coming inflation, if you have savings in sterling, then they are not safe. I used to be against the Euro in principle but warned those who were keen on keeping the £ that it was not in safe hands. The first major crisis has unfortunately proved me right on the latter count. But trouble with the Euro could still happen as the problems in Spain, Italy and elsewhere take their toll. Seemingly, however, the European bankers are, so far, prepared to take a tougher stance to protect the value of the currency. But when the £1 drops to the same value as the Euro, the UK will not be allowed to join as they will not want to absorb the UKs losses by taking on the devalued currency.