The campaign to bring down the cost of living by raising the cost of mortgages continues over at the Bank of England (BoE). Someone needs to tell them that paying your mortgage is part of the cost of living, whatever their statistics might say…

Not only that, asking mortgage borrowers, specifically, to bear the brunt of the hand-break turn that the Monetary Policy Committee (MPC) is trying to perform has its own risks.

Funnily enough, it risks upsetting precisely the BoE’s other policy mandate – financial stability. Ironic, isn’t it?

But before we get to that, just how bad is the stress in the mortgage market?

According to a Hamptons researcher, the share of people’s incomes going towards mortgages is nearing its 1989 peak – a time my aunt still calls “when money was scarce”. But how high is that?

Over half!

That is, over half of people’s incomes would go to their mortgage payments…

In fact, quite a bit over half, at 56%. That’s much worse than the 2007 peak of 49%, where we were at earlier this year.

Throw in the expected upcoming interest rate hikes, recent inflation rates and real income falls and you get quite a combination of financial pressure on households.

Things are so tight that banks are pulling mortgage offerings – a real sign of trouble because of what it means for the money supply in the economy. But back to that in a moment.

One of the underlying misconceptions here is about the nature of financial risk. For every winner in the financial markets, there is a loser. Or, at least, someone who missed out on a gain. That’s part of what sucks about the financial markets.

This doesn’t mean it’s a zero-sum game. It means you can shuffle risk around the economy from those who can’t bear it to those who can.

For example, one of the first uses of the financial contract known as a “future” was for wine. Wine futures allowed wineries to sell their upcoming wine before it had been harvested or produced. This both funded the winery’s operations and de-risked them.

A bad vintage of unsellable wine due to poor weather didn’t send the winery bust anymore. Instead, the wine merchants or wine buyers bore the risk by entering into the futures contract to buy the wine at a fixed price early on.

Wine merchants learned that they could diversify enough to escape ruin and that the typical gain from a good harvest outweighed the typical loss on a bad one. Everyone benefitted and wineries were given the long-term stability that allowed them to create better wine over time.

Similar olive oil futures may have been around during Aristotle’s time. And the terms bull and bear come from bearskin futures in Colonial America. These helped hunters figure out which furs were actually in demand and worth hunting for before they went out hunting for them. The market settled before people took on the risk of deciding what to shoot and bring back.

Now, back to today. While the innovations of mortgages and different ways of managing risk may well be good, they merely transfer risk around the financial system. Fixed and variable interest rates, which the media is focusing on, are an example of this.

While UK mortgage borrowers on variable-rate loans are getting shafted by interest rate hikes, in the US and other places with longer term fixed-rate loans, it’s the banks that get into trouble instead. Their incomes are at low interest rates and their cost of funding is now much higher. They’re getting squeezed.

Now, I’m sure this sounds preferable to readers in the UK. But it risks a banking crisis, which is very bad. Indeed, central banks, which now exist to cause control inflation, originally existed to promote financial stability in the banking system. But their attempt to bring inflation back down to target is precisely what threatens financial stability today.

In other words, they have a conflicting mandate: financial stability versus purchasing power stability. They can’t bring down inflation without risking the health of the banking system.

This now applies not only in the government bond market, as exposed by the BoE’s return to quantitative easing (QE) policies during the Truss-Kwarteng bond plunge, but also when it comes to people’s mortgages today. Every interest rate hike to rein in inflation threatens another financial debacle.

This is especially true because of one of the BoE’s policies to safeguard the financial and mortgage system from precisely the problem we’re facing. They call it stress testing. But this time, instead of the banks being stress-tested, it’s the banks doing the stress testing…

People who borrowed had to be stress-tested against interest rate increases. The policy varied around the world. In the UK, they were stress-tested for a 3% increase in interest rates. Unfortunately, the BoE has now raised interest rates by almost 4.5%. And did so at an unprecedented pace in a financial system that it levered up with prolonged 0% interest rates with the hinted at promise to keep rates low for a long period of time.

But now the requirement to stress test has bankers applying a 3% test to 5% interest rates for an 8% total, and that’s expected to rise as BoE interest rates do. That’s a mortgage rate not many can afford. And so, mortgage lending is crashing.

The Telegraph has the figures:

Bank of England data showed the property market is already feeling the strain of higher rates.

Mortgage lending fell sharply in the first three months of the year as buyers pulled back in the face of rising costs.

A total of £58.8bn was loaned out to homebuyers, down almost one-quarter compared with the same period of 2022 and the lowest level since the depths of the pandemic lockdown of spring 2020.

Isn’t less debt a good thing?

It’s supposed to be. But in our present monetary system, it creates a new problem.

You see, banks don’t technically lend out the money that you deposit with them. They also don’t technically borrow the money that they lend out. They actually create the money that they lend to borrowers. And so fewer lending means there’s less money sloshing around in the economy.

If that’s confusing, consider that the same applies to your credit card spending. The money doesn’t come from somewhere. It is created in the act of spending. And then extinguished in the act of paying off your credit card. Money is not an asset, but an IOU.

And so less credit card spending and mortgage borrowing means less money in the economy. That is the very definition of deflation, even if modern economists tell you that the mere symptom of falling prices is what we now call deflation.

Just as central bankers underestimated the threat of inflation due to their policies, they now underestimate the threat of a financial crash and deflation due to their policies. By the time that the review into the BoE gets underway, it’ll have to change its focus from inflation to general incompetence.

Of course, none of this need be a problem if only the government and central bank controlled the financial system directly via a central bank digital currency (CBDC). But then we could have something far worse to worry about…

Until next time,

Nick Hubble
Editor, Fortune & Freedom