Is Britain heading for a crash?

It was all going so well. The UK economy had been experiencing uninterrupted growth and low inflation for over a decade. And then Northern Rock went bust. At least, that's what Gordon Brown and Alistair Darling would have you believe.

After five months of dithering, the Government is hoping that nationalising the bank will draw a line under the whole sorry saga. But it seems likely that its woes are only just beginning. A protracted battle with aggrieved shareholders lies ahead; EU competition authorities and other banks are likely to take a dim view of the idea of the bank being run as a going concern until a new buyer can be found; but as MPs belatedly realised this week, the Rock's business model depends on it being able to continue to write new mortgages to feed its offshore Granite securitisation vehicle. Shadow chancellor George Osborne put it rather well when he said: "We don't know what we're buying, we don't know how much we're paying for it, and we also don't know how long we're buying it for."

That's all bad enough. But in terms of economic woes, Northern Rock is just the tip of the iceberg. The collapse of this second-tier bank has finally drawn attention to the fact that there's something badly wrong with the UK economy, and that much of the apparent success of the past ten years was illusory.

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It's certainly highlighted these woes to foreign investors. Simon Derrick at Bank of New York Mellon told the FT that it's "difficult to underestimate Northern Rock's negative impact on sterling during the past six months". Since the news broke in September that the bank needed emergency funding, sterling has fallen nearly 10% against the euro. The simple fact is that, just like a broken bank, people don't feel safe leaving their money here anymore.And they're right to feel that way.

Northern Rock was a badly run company whose success and high share price was an illusion based on reckless borrowing and an unsustainable property boom. Sadly, that's a pretty good description of the UK as a whole. Here's why.

The Government has spent too much

Gordon Brown and his protg Alistair Darling like to point to the UK's long record of growth and low inflation, arguing that it proves their economic policies have worked. In his first big speech after becoming chancellor, Darling observed that the global economy faces its biggest test in more than ten years, but argued that in the UK, "we have good reasons to be confident".

But Albert Edwards at Socit Gnrale takes a rather different view, commenting recently that the parlous state of the UK's public and private finances now leave it close to "Banana Republic status". Unfortunately, his conclusion is far closer to the mark.

Yes, we've had low inflation and steady growth. But this growth has been dependent on low interest rates, which in turn have been driven by external factors that are now ending. Bank of England governor Mervyn King confirmed in his latest quarterly speech that a decade of low inflation, thanks to cheap imports from emerging markets such as China and India, is over. Ignore these factors and the underlying economy actually looks pretty poorly. The latest Barclays Equity Gilt Study reveals that the past decade was the worst for UK equity performance since the period from 1967 to 1977. And that was a grim decade that featured sporadic Opec oil shocks and stagflation hardly a ringing endorsement for Brown's "miracle economy".

The other big driver of growth has been public spending. As The Daily Telegraph's Ambrose Evans-Pritchard observes, on this front we are a "budget basket case". Brown's much-hyped Golden Rule, which allows the Government to borrow provided the capital is invested, has done nothing to prevent us building up far too much debt during the good times. Our budget deficit has grown to more than 3% of GDP just as other countries have been trying to reduce theirs.

Capital Economics predicts that, even in the event of a relatively mild downturn at any point soon say a 1% fall in GDP in 2009 the fiscal framework will be "blown to smithereens" with public borrowing rising "as high as perhaps £100bn or even £150bn per annum" (and that's even without Northern Rock) more than enough to threaten the UK's credibility and raise our external cost of borrowing.

Meanwhile, at 5.7%, our current account to GDP ratio is beaten only by Spain, while the state's share of the economy, now that Northern Rock has been added to the public-sector balance sheet, stands at 45%, according to OECD figures, putting us above even Germany for the first time in 30 years.

Why does this matter? Because if the UK heads into a slump, the Government is now too indebted to help consumers and corporations out by cutting taxes. In fact, should the tax receipts that pay for our bloated public services start to fall, the Government faces a diabolical three-way choice substantially raise taxes, drastically cut expenditure, or allow state borrowing to spiral out of control. Unfortunately, this is a choice it may be facing sooner rather than later.

The property market is in trouble

Edmund Conway in The Daily Telegraph argues that there might be a bright side to the Northern Rock nationalisation. "Unless the housing market suffers a major crash, there is every chance of squeezing some profit out of the company." The trouble is, a crash is precisely what's around the corner.

After the Bank of England's misjudged interest-rate cut in August 2005, which helped to re-ignite the property boom, any hope of a soft landing for UK property disappeared. UK household debt now stands at 103% of GDP, above even the 85% figure the US recorded just before its housing market collapsed. The market has been propped up by the availability of cheap and easily attained mortgage loans and a rampant buy-to-let sector.

The housing market's dependence on investors, rather than first-time buyers, is amply demonstrated by recent figures from Halifax, which show that the number of owner-occupiers in the UK actually fell by 83,000 last year. That's the biggest drop on record and the second annual fall in a row.

But the cheap credit bubble has burst as the crisis in the US housing market revealed that lenders had become too careless and overstretched themselves. And despite protests to the contrary from Alistair Darling, in the UK lenders have been just as reckless, partly due to the failure of the tripartite' model of regulation, set up by Gordon Brown. This split responsibility for banking oversight between the Treasury, the Bank of England and the Financial Services Authority, and quite simply, as Larry Elliott points out in The Guardian, "did not work". No one intervened to challenge Northern Rock's business model, which relied on an endless supply of cheap short-term credit, with the result that the taxpayer is now lumbered with a broken bank.

Many other lenders, to a lesser extent, relied on similar funding models, with the result that now the credit bubble has burst, they are having drastically to rein in lending 40% of mortgage products disappeared in the three months to the end of 2007. And just this week, the vast majority of lenders stopped offering the instant negative equity mortgages' that allowed people to borrow more than 100% of the value of their homes.

The consequences will be with us for years. The number of repossessions hit a ten-year high of 27,100 in 2007, but this will climb far higher. As Kate Barker, a member of the interest-rate-setting Monetary Policy Committee pointed out this week, many homeowners will face a "significant" shock in the months ahead as their mortgage bills suddenly leap. In what The Daily Telegraph described as an "unusually downbeat" speech, she warned that "it is likely that prices will decline in the short-term relative to earnings, and falls in nominal terms cannot be ruled out".

Others are less ambivalent. Merrill Lynch expects to see falls of 5% in 2008, and nearly twice that in 2009. James Ferguson, economist and stockbroker at Pali and regular MoneyWeek contributor, reckons prices could fall by 30%-40% from peak to trough. And this is all happening now January's figures from the Royal Institution of Chartered Surveyors revealed it was the worst month for the UK housing market since the last recession in 1992, reported Kim Mai-Cutler on Bloomberg.

Sadly for the taxpayer, Northern Rock was one of the most aggressive lenders at the height of the housing bubble. That potential profit is looking more and more like turning into a whopping great loss by the day.

Job losses will follow

The optimists on the UK economy point to the fact that unemployment is at a 30-year low. However, this is actually bad news. If the economy is already looking so weak, when employment is so high, how much worse will it become when job losses start to creep up? And creep up they will. Consumption accounts for about 70% of UK GDP.

But consumption in turn has been fuelled to a great extent by consumers borrowing money against their houses and on their credit cards and running down their savings. With lenders of all stripes cutting back on loans, and bad debts and repossessions rising, spending will have to fall, which will hit corporate profits, which in turn means job losses.

And the UK is particularly vulnerable. In fact, Roger Bootle of Capital Economics reckons the jobless total could hit two million by the end of 2009, which would be more than double current levels. Outside the financial sector, employers have been holding back from cutting staff costs, so current unemployment data conveys a false sense of security. One of the reasons that many employers base themselves here rather than overseas is our highly flexible labour laws. Hiring and firing across many key sectors, including financial services, building and tourism, is significantly cheaper and faster than in much of mainland Europe.

As a result, employers can afford to "hoard" labour for now and act later once the severity of the current downturn becomes clear. And once service-sector firms start shedding jobs, it happens quickly due to their high levels of operational gearing. Most services firms carry just two fixed costs that eat up the lion's share of revenue property and people. When things get nasty, it's the wage bill that employers look to cut, via redundancies. That's why financial data firm Experian sees up to 20,000 (5%) of the UK's financial services jobs being cut within 18 months.

Life in the UK is getting too expensive

The slowdown in the housing market is already having an impact on one group of UK residents in particular Polish immigrants. The Poles, who have become emblematic of the cheap but efficient foreign labourers who have been giving our domestic tradesmen a run for their money in recent years, are packing up to go home.

According to the latest Government figures, only 38,860 Poles signed up to the register of migrant workers in the third quarter of 2007, an 18% drop on 2006. Krzysztof Trepczynski at the Polish Embassy in London said the figures represent a "tipping point"; Jan Mokrzycki, president of the Federation of Poles in Great Britain, told The Times: "The first thing that's been hit is the builders. There's no doubt about it."

But the mass exodus isn't just down to the shaky jobs market. According to many Poles interviewed by The Times, the UK is simply no longer as attractive an option as their homeland, which is experiencing strong economic growth. "Living costs are much higher here," said one respondent and "the zloty value of my sterling savings keeps falling" said another. Those comments encapsulate the other big problem faced by anyone living in the UK spiralling living costs, exacerbated by the crumbling pound.

Although the retail price index is running at a modest 4.1%, this conceals the fact that the price of all the non-discretionary stuff we have to pay for day in day out is rocketing. Food price inflation is already at 6.6% and likely to jump further as the globe continues to battle shortages of everything from wheat to soybeans.

Meanwhile, home energy bills have spiked by 15% since Christmas on the back of rising oil and gas prices enough to add half a point to consumer price inflation. A falling pound just piles on further pain by stoking up the cost of imported goods, which are already heading higher as a decade of cheap manufacturing in emerging markets inflation in China is now running at an 11-year high comes to a close.

This is the main reason why those hoping that the Bank of England (BoE) will ride to the rescue by reducing mortgage costs using aggressive interest-rate cuts are likely to be badly disappointed. Unlike the US Federal Reserve, which seems oblivious to decade-high inflation and has slashed rates by 125 basis points in a matter of weeks, the BoE seems more concerned about sticking to its brief of keeping CPI inflation at, or near, 2%.

As The Economist notes, the BoE's forecasts for inflation suggest that the base rate will fall no further than another 50 basis points from the current level of 5.25%. And as Mervyn King pointed out recently, even if rates were to fall, there's no guarantee that banks, scrabbling to maintain their profit margins, would pass on any relief to consumers. Indeed, the country's biggest mortgage lender, Halifax, has just raised rates on its tracker mortgages by 0.2%, despite recent base-rate cuts.

By leaving en masse, the Poles are effectively saying go long Poland, and short the UK. It's come to something when a former Communist country looks a safer bet than one of the world's largest economies. While we're not saying you should necessarily buy Poland, we agree that you should sell the UK and we have some suggestions on how to do it below.

How to sell out of the UK

You could try buying a property in Poland to benefit from reverse migration but there are easier ways to profit from the coming downturn. Spreadbetting is one way to follow HSBC currency strategist Dwyfor Evans's advice to "stay away from sterling". Specifically, James Carrick at L&G predicts a further 10% fall against the euro, and up to 25% against many Asian currencies in the medium term. You can profit from this through a broker by selling the relevant currency pair, such as GBP/EUR, or GBP/JPY, but remember that exchange rates can move quickly, so always consider stop losses should your down-bet backfire. For more on spreadbets, see Moneyweek.com.

Another option is to bet on falling property prices. Firms such as IG Index let you place a down-bet based on the Halifax House Price UK index between now and either March or June. Currently, they are quoting a June spread for UK property of 187.1/190.7 (where 187.1 equates to a price of £187,100). Were you to sell that spread now at £1,000 a point and by June the HBOS index is at, say, 185.0, you will make (187.1-185) x £1,000, or £2,500 tax free. Bear in mind, though, that this would require a steep drop from the published January index figure of 197.2 and remember, if prices fell by less than you expected, you could lose your entire stake or more.

If spreadbetting is too risky for you, then gold is a good play on general currency weakness. As currencies like sterling and the US dollar continue to fall, gold's attractiveness as a store of value can only grow. An easy way to gain exposure is using an ETF, such as ETF Securities' Physical Gold (LSE:PHGP), which is priced in sterling.

UK exporters should also benefit from a falling pound, as it brings down the cost of their goods and services for overseas consumers. It's another good reason to buy big defensive healthcare firms, such as AstraZeneca (AZN) and GlaxoSmithKline (GSK). As for what to avoid, the uncertainty about total losses from the credit crunch means we would still avoid banks, despite their apparently high yields. Equally, pressure on UK consumers means we remain very wary of retailers, pubs and restaurant chains.