Seven steps to ruin

It is Saturday; it is sunny outside; at least it is here in London. Let us bring the mood down and consider the calamitous prospects facing the UK economy.

Things are bad, but it is going to get worse. Here are my seven steps to economic ruin. As always, it starts with the great distortion that has twisted the UK economy into a debt-addicted mess - the housing market. It ends with a banking crisis and a government bailout.

Step 1 – UK Households try to pay down the debt

The overextended UK consumer is in the driving seat for this trip. For the last ten years, households borrowed as if the world was about to end and no one was going to ask for the money bank.

The extent of UK personal sector indebtedness is truly frightening. Today, individuals owe around £1.4 billion, which is well north of 100 percent of GDP. About 85 percent of personal debt are mortgages and home equity loans; the rest is owed on credit cards and unsecured loans.

What encouraged this explosion of lending? The housing bubble; people took out loans to pay for overvalued houses, believing that these overpriced assets would continue to appreciate.

Today, the UK personal sector has reached saturation point; it cannot soak up any more debt. Many households are suffering from payments difficulties. Sentiment is about to shift; the spend fest is about stop and people will try to reduce their debt levels.

Step 2 - Consumption declines, economy begins to slow.

There is only two ways that people can reduce their debts; either earn more or spend less. Unfortunately, the first option is not available. UK real wage growth is now negative; the latest average earnings data shows wage growth at 3.8 percent but RPI inflation is running at 4.1 percent. If earnings will not grow, then spending must slow. The aggregate effect of all those little decisions to cut back on spending will be a reduction in aggregate consumption, which makes up about 70 percent of GDP. It will not take much of a fall in consumption to make a serious dent in economic growth.

Step 3 - Unemployment begins to rise

As people reduce their consumption and as the economy slows, firms will begin to fire workers. The unemployment rate will begin to rise. However, there is no policy-driven escape strategy available.

As soon as the dole queues begin to increase, the Bank of England will face irresistible demands for drastic interest rate reduction. However, lower rates will only exacerbate the UK's macroeconomic imbalances. It will push the sterling exchange rate down, and as imports become more expensive, inflation will rise. Lower rates will not help the housing market much either. Banks are already in way too deep, and want to reduce their exposure. Lending standards have already tightened up. The days of easy credit are now over.

The government will not have much room to use fiscal policy as a recession-evading tool. For the last two years, public sector deficits have grown dramatically, in effect, propping up the economic growth. Higher government deficits would push up long-term interest rates as investors become increasingly wary of buying government debt.

Unfortunately, higher unemployment seems inevitable, and here is where the banks really need to start worrying.

Step 4 - Default rates begin to rise, repossessions increase, and housing prices collapse.

It is an obvious point, but unemployed people invariably have difficulties paying their debts.

As the default rate rises, repossessions will increase. Soon, this additional housing inventory will push the house prices down. Forget all that rubbish about pent up demand from real estate agents; there will be plenty of supply when the economy slows.

Recent housing data is already showing a market under enormous stress; house prices have been falling since July 2007; mortgage approvals are down dramatically, and default rates are already creeping up. Notwithstanding this slowdown, the worst is yet to come.

Step 5 - Bank losses increase

Given the enormous levels of mortgage debt out there, it would not take much of a rise in unemployment to push the default rate up to dangerous levels; dangerous that is, for UK banks. While repossessions are a personal tragedy, for the banks, a rising default rate on mortgages is a mortal danger. It was the banks, with their reckless lending, who inflated the housing bubble. They provided the rocket fuel; without the double-digit growth in mortgage lending, there could be no double-digit growth in house prices.

Step 6 - Bank failure followed by panic

Banks fail when people stop paying them back, their assets evaporate, and as the banks go down, depositors find their money trapped in bankrupt institutions. Even the very thought of a failure is likely to prompt a run on a bank. We have already seen how quickly a bank can turn bad. Last summer, Northern Rock crashed in just a few short days. Although Northern Rock did not prompt a run on other banks, UK depositors had their confidence in banks severely tested.

However, banks are more than just lending institutions; they play a vital role in the payments system. A smooth settlement of accounts is the cornerstone of a properly functioning economy. Money trapped in failed banks cannot be used to pay bills, wages or taxes.

Step 7 - Ruin

No economy can allow a systemic banking failure. When banks fail, the government has to step in and rescue the payments system. Ultimately, this is probably where the UK banking system is heading. As banks wilt under the weight of defaulted mortgages, we will see the nationalization of a fair chunk of that housing debt. The Bank of England will extend emergency loans to bankrupt banks, and the government will pick up the tab. If anyone thinks this is far-fetched, just remember Northern Rock. That little failure has already added 6.7 percent to the government debt.

Surely, you exaggerate.

It is a dismal perspective, to be sure, but there are good reasons to worry. Rising government indebtedness, banking failure, tanking house prices, and increasing unemployment; that is one toxic brew, but it could be where we are heading.

For those who think this scenario seems a little far-fetched, sit back and thing about the following point for a moment. Last year, UK banking sector managed to pull off three incredible feats; it engineered one major bank failure, the first in over one hundred years; it kept financing the housing sector when every available indicator suggested overvaluation; and it accumulated losses without the economy actually slowing down. Can you imagine how bad things could get when the economy does finally begin to grind to a halt?

Make no mistake; the UK banking sector is an accident waiting to happen.