For UK, cliff diving is its best attribute: James Saft

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft

LONDON, Nov 11  - Britain is entering into a painful economic experiment: what happens when house prices fall farther and faster than ever before and you cut interest rates to a 300-year low?

Counter intuitively, the size and velocity of Britain's housing crash may actually be the best thing it has going for it at the moment.

Seeking to rescue an economy dependent on the busted flush of finance and property speculation, the Bank of England made only a down payment last week when it cut interest rates by a full percentage point and a half to a 50-year low of three percent.

The Bank, founded during the reign of William and Mary in 1694, has never reduced its benchmark rate below the 2 percent level touched many times in the 19th century and again between 1939 and 1951.

But I'd add my vote to the 18 of 48 economists polled by Reuters who are forecasting rates to be below that historic level by the middle of next year.

The rate of deceleration in Britain's economy is shocking; its banking system has required state aid and may well need more while its consumers are maxed out on credit and increasingly looking for work.

Perhaps most breathtaking is the speed with which Britain's property market is imploding.

The Halifax benchmark index is down 15 percent in the year to October, having fallen by 2.2 percent in that month alone. By comparison, in perhaps the worst year of the extended 1990s housing downturn, British property prices fell just over 8 percent in the 12 months to December 1992.

"The housing crash really is, in real or nominal terms, bigger and faster than we've ever seen before" said Ed Stansfield, a London-based economist at Capital Economics.

"The sooner we get to some scenario where people think property is cheap and the risks of buying are less, the sooner the economy begins to move forward again."

House price crashes are usually extended, grinding affairs, and much the worse for the economy for being that way. Few sellers want to take the pain of selling at below what they imagine their house to be worth, and everyone thinks their place has some special merit which means it can escape a general downturn.

As a result, prices are slow to reset downward and associated economic activity -- building, furniture, legal and real estate services -- take a long hiatus.

In the year after prices in the UK peaked in 1989, they fell by only two percent, against 10 percent in the year since the July 2007 peak. The U.S. crash has also been much slower, with the S&P Case/Shiller 20 city index falling by only about six percent in the year after its 2006 peak.

GETTING IT OVER WITH

Capital Economics, which is forecasting another 20 percent off house prices next year, estimates that a sharp two-year fall in prices would have less than half the impact on lost economic output than a more typical four-year adjustment.

One risk is that a large and rapid fall brings with it a large overshoot and that housing prices carry on falling even when they become fair value in terms of the income a house can generate or in relation to wages and interest rates. These things take on a momentum of their own.

It is also far from certain that banks will be willing or able to pass on all of the coming cuts in interest rates, given their own high cost of funding and the imperative of rebuilding their capital.

"Yes, lower rates will be useful, but the transmission mechanism will be impaired," said George Buckley, a UK economist at Deutsche Bank in London.

"A fair bit has been passed through but with a lot of pressure from the government. Even then you are seeing the spread actually increasing on tracker rates for new mortgages and some (mortgage) products are being removed altogether."

Of real concern too is what a 35-40 percent fall in house prices might do to the capital base of Britain's banks. A slower crash would definitely be in their interest, allowing them to manage the loan books more effectively and giving them time to rebuild capital. Insolvent banks won't just choke housing finance, they would withdraw lending from all sectors of the economy.

Strange to say, but we might almost have gotten past the point where increased bank woes lead proportionately to diminished credit provision.

Governments, in Britain especially, may simply have to up their equity infusion into the banking system beyond the tens of billions already agreed in state-funded capital and compel banks to lend. Look for a host of pretty horrible unintended consequences if that happens.

"The government have passed the point of no return; the only question is how big the cheque they need to write is," Stansfield said."