Where are we heading?

There were two financial reports coming out of the United Kingdom today – housing prices and general inflation. These reports petrified me – just as similar data from the US these days is causing a concern to me.

The housing prices in the U.K. have been going up at a pretty pace recently. The annual housing prices went up by 9.6% in the year to the end of March. The annual house price inflation in Scotland during the same period was 14.6% – the fastest since 2007.

Now, the general inflation in U.K. (as measured by the Consumer Price Index) turned negative (-0.1%) in April (year-over-year).

The two contradicting data above points to eerily similar situation during the housing boom before 2008. For the last decade, we have been facing this constant problem of asset price inflation not in line with the inflation of the prices of general goods and services. Now, remember, the central banks base their interest rate decisions on the consumer price index and not on the housing price index. In fact, before the 2008 recession, many central bankers thought that housing price inflation was not something to worry about. They did not believe that there could be a nation-wide housing market collapse – as they thought that housing price depends of various factors, many of which are regional. But what they failed to see was how the housing market was directly linked to the very heart of the global finance and how the collapse of the housing market could cause a chain reaction across many large financial institutions.

It would be hard to believe for anyone to think that the central banks did not foresee the link between the housing market and the banking system – as even in a traditional banking model, it is the banks which lend to the home owners and so anyone would have known that there would be an impact if the housing bubble bursts. But the irrational calculation that the central banks did at that time was that a bank, run by extremely savvy individuals, would not hurt itself by sub-par lending standards (we would call this “no-regulation”, but the central banks called it “self-regulation”). But what the central banks missed to see at that time was – it was no longer necessary for the banks to worry about the creditworthiness of the borrower – as long as the banks could securitize those loans and sell it to market participants, they thought that the risks were minimized. In fact, they thought that by selling these newly innovated financial products, the risks were shifted from just the lenders to the many number of financial market participants – participants who were more in number than one lender and who were thought to have the capacity to absorb the hit if in case the borrower defaults. These securitized loans were complex financial instruments that went under the radar of the supervising agencies of the government. So when the housing market collapsed, it set up a chain reaction with these financial instruments acting as a trigger that led to an incredible worldwide turbulence in the global financial markets - a turbulence whose effects are still being felt today, and a turbulence that brought us close to the complete shutdown of the global financial system as we know it.

Today, after ‘n’ number of new regulations introduced, various bank stress tests conducted, billions in fines paid and bills like the Dodd-Frank passed, we are again looking at data that points to assets like houses and equities going up when wages and inflation of general goods remain stagnant. Where did we go wrong? More importantly, where are we heading?