Noticed how everyone is changing their tune. A flat housing market is giving way to a ’shallow’ drop. Now the penny has dropped and the numbers are becoming larger.

With the British Chamber of Commerce survey of 5,000 businesses out today, we now know we are in serious risk of a recession.

Well, use real inflation figures (not the cosmetic official ones) and we are in recession now. Spending has been financed by credit cards. Increasingly, people are even using credit cards to pay their mortgage. How dangerous is that? Using short term debt (at high interest) to pay long term debt. The Third World Debt crisis (of yesteryear) has now arrived in UK PLC.

Commentators are now pencilling in a ‘worst case scenario’ of 20% drop in residential house prices by the end of 2009. Well, does the world end on December 31st 2009? What about 2010 and 2011? Do house prices miraculously shoot straight back up? Afraid not.

One member of the Bank of England’s Monetary policy committee let the cat out of the bag when he suggested the property market isn’t ‘coming back’ into strength before 2018…… a full ten years away.

Let’s encourage such longer term perspectives, including looking back. Unfortunately, too many people believe the credit binge of 2001 to 2006 was normal. It was not, and it’s not coming back any time soon, if ever.

We all agree that American house prices are crashing. They are down 17% from the peak of 2006 and looking to drop to 25% or more.

At what level should UK house prices be? Let’s be old fashioned and compare mortgages to earnings.

The house price to income ratio in the UK used to be just over 3, i.e. mortgages about 3.2 times above income. That moved to 5.5 times in 2006. Way, way out of kilter.

The snapback has barely started. For the ratio to return to its long term average of 3.2, house prices in the UK would have to drop 45%. In other words, the £300,000 ‘asset’ collapses to £165,000.

Why not? If it can triple from £100,000 to £300,000 since 1996, it can also get back to some sane level.

Always remember Japan. In Tokyo, house prices declined 70% in fifteen years, after 1990. We find it difficult to understand how so many people ignore the japanese experience. After all, it is a richer, more sophisticated economy than UK Plc (especially if one is more impressed with hi-tech manufacturing, rather than the witty inventiveness of City boys producing more ’investment paper’, rather than electronics). Despite the long era of deflation, Japan remained one of the world’s largest economies. There was no blood on the streets.

If it can happen there, it can happen here. The UK residential market is absurd and depending on a vibrant financial sector….. 

Q: which is the most vulnerable sector right now?  Financial sector.

Which shares would you least like to own?  Banks and housebuilders.

Which two sectors does UK PLC rely on the most? Finance. Followed by? Housing….

It makes us wonder how people think one should get into debt to the tune of £350,000 to purchase a terraced house in, say, Barking, in Essex? Many did. A 45% drop would bring that house to £193,000. Massive negative equity for a decade or more. 

 What’s the engine of growth in that area? Used to be Ford car plant (one of the largest) in Dagenham. That went years ago. Now, it’s the destination for commuting workers to the City…… But not much else. So what happens when tens of thousands of jobs go in Canary Wharf and the City? A sharp drop in demand for housing and a collapse in the local economy (restaurants, clubs, nail salons, estate agents, mortgage brokers, clothing stores, furniture shops, consumer electronics……..). As an aside, perhaps betting shops and (some) pubs, pawnbrokers and repair/maintenance outlets will thrive.

You can multiply this scenario up and down the country. And while there won’t be ‘blood on the streets’, it will be a lot messier than Tokyo (think social cohesion, nasty politics and crime).

Japan shows that even during deflation, and imploding asset prices, life does go on and some companies thrive. Just remember, it won;t be the financial sector for a decade.

Which means the engine of growth for London (and therefore UK PLC) is about to stall, with a dramatic change downwards. A whole generation of ‘get rich quick’ property owners are going to be ruined as the banks leave them high and dry. You may not agree today though we are sure you will next year.

The problem is, we cannot figure out which sector is going to replace finance and housing to provide jobs and keep the economy afloat. Once manufacturing jobs and factories fly abroad, it’s next to impossible to get them back. So what is it going to be?