British observers have in the last year indulged in a considerable amount of schadenfreude about the US subprime crisis, the excessively expansionary monetary policy of Fed Chairman Ben Bernanke and the substantial recession that appears impending. They should be less eager to gloat; the recession into which Britain is heading is likely to be considerably more serious than its US counterpart, and the way out less certain.

One reason for Britain suffering a deeper recession than the US is that its house prices got more out of line. Whereas in the United States, the house price to income ratio peaked at 4.5 times, against a long term average of about 3.2, in Britain in 2006 the house price to income ratio peaked around 5.5 times. Housing is more tax advantaged in the United States, since mortgage interest payments are tax deductible unlike in Britain. Hence the equilibrium British house price to income ratio would appear to be about 3 times, marginally above the 2.7 times level of 1970, when the British housing market was close to equilibrium. That implies that an average fall in real British house pieces of 45% is needed to bring the market back into equilibrium, considerably larger than the 29% drop needed to bring the US market into equilibrium.

Those figures may seem startlingly high but remember: the average Tokyo house price dropped by no less than 70% between 1990 and 2005, as Japan’s 1980s stock and real estate bubble deflated. Thus a 45% drop is perfectly within the bounds of possibility. The US housing market appears well on its way to the necessary 29% correction, with the Case-Shiller house price index already down 18% since late 2006. Conversely, the British market has only just begun to drop in price, with current national average prices down by no more than 5%. Hence the future economic effect of the housing downturn is likely to be considerably more pronounced in Britain than in the US.

There are however other reasons for believing that Britain is likely to have a deeper recession than the US, the principal of which is the different structure of the British economy. Not only is it more finance-oriented than that of the United States, but its finance sector appears considerably more vulnerable, largely because of the lack of locally-controlled institutions involved in it.

One of Shakespeare’s better-remembered lines, from Julius Caesar is:

“The evil that men do lives after them
The good is oft interred with their bones.”

For almost no political leader has this been so true as for Margaret Thatcher, thankfully still with us but surely watching in horror as the positive parts of her legacy disintegrate while her few mistakes return to haunt us in ever more terrible form. She cut back the size of the bloated British public sector – but it is today larger in terms of Gross Domestic Product than when she came to power. She brought a new assertiveness to Britain’s relations with the EU – but today the EU is forcing through a treaty that would be rejected by an overwhelming majority of the British people. With Ronald Reagan, she brought about the fall of Communism – but today Vladimir Putin’s Russia is as threatening to the West as any Soviet regime since Josef Stalin died, and we can’t even rely on the inherent contradictions in its economic management to weaken it. She brought a new self-discipline and self-respect to the British people – but today the British people are as wayward and feckless as they have ever been. She more or less invented privatization – but today that technique of extracting assets from the dead hand of government is little used, and the net British and global trend appears to be towards more state control, not less. She defeated the Trades Unions, an achievement that still stands – but maybe they would have been defeated anyway by the forces of globalization and the disintegration of the British manufacturing sector.

As for her mistakes, we have been given a stark reminder this week of her first major political blunder, the 1979-80 Lancaster House settlement of Rhodesia/Zimbabwe. When she came to power, an internal settlement for that country had been achieved and a majority-population prime minister, the moderate and respected Bishop Abel Muzorewa, had come to power through elections agreed by international observers to be free and fair. All she had to do was ratify the process that had produced Muzorewa, regularize Rhodesia-Zimbabwe’s independence, and provide a certain amount of aid and investment, and Zimbabwe would have become a beacon of relative prosperity in the continent and a staunch British ally.

Instead Thatcher succumbed to the politically-correct machinations of her feeble Foreign Secretary Peter, Lord Carrington and the incorrigibly-leftist Foreign Office, and forced a settlement that deprived the elected incumbent government of office and allowed the Marxist terrorist Robert Mugabe to intimidate his way to power. Mugabe has been there ever since, representing no sort of democracy and driving his terrorized populace into ever greater misery and penury. Seldom if ever has political feebleness brought such catastrophic results – none of which have accrued to the prime minister responsible or the electorate that chose her expecting better.

Thatcher’s reorganization of the City of London by the Financial Services Act of 1986 is likely to produce fewer actual fatalities but in the long run may be even more damaging, at least economically. It was designed on a wholly fallacious theory that London’s financial “playing field” should be leveled, in order to produce a more competitive marketplace. It abolished market structures that had worked well for close on 300 years, replacing them with an inferior copy of the structures prevalent in New York. It was implemented shortly after a decade in which the British merchant banks had been devastated by recession and near-hyperinflation, so that in real terms they were a quarter the relative size they had been in 1970. The result of removing the market mechanisms with which local houses had been familiar and subjecting them to fierce competition from much larger foreign banks (who themselves remained protected in their domestic markets) was inevitable; within 15 years of the Act’s passage the London merchant banks were not merely foreign-owned but non-existent. It was the most suicidal British economic legislation since the 1846 Repeal of the Corn Laws.

The long-term damage to Britain’s economy caused by the 1986 Act has been a generation in arriving, but appears now to be upon us. At the twentieth anniversary of the Act’s implementation in November 2006 there was much bien-pensant rejoicing, with declarations that the City and Britain in general were incomparably more cosmopolitan and better off as a result of it. As we now know, that rejoicing was premature, since the anniversary coincided almost precisely with the apogee of the financial services bubble that has since so damagingly begun to implode. The fancy bonuses achieved by the remaining British bankers, kowtowing vigorously to their masters in Frankfurt, Paris, Zurich or New York, are unlikely to be matched again for at least a couple of decades, if ever.

It seems most likely that the financial services industry, which approximately doubled its share of world value added between 1980 and 2006, will shrink back to somewhere close to its original size. Many of its “innovations” such as securitization turn out to have had fatal flaws in their incentives design that produced aberrant and in some cases criminal behavior by participants. Global overcapacity in the sector is likely to reduce both individual remuneration and the fees charged by financial institutions. The multi-tiered investment management business, in which many funds were distinguished solely by the splendor of their fee structures, is likely to shrink back to a modest economic activity that competes mostly on price. A return to much tighter monetary policy and real interest rates well above zero will greatly reduce the amount of loose money sloshing around the world looking for a home.

Britain is likely to be more deeply affected than the US by a prolonged implosion in the financial services business for three reasons. First, and most simply, it is a more important part of the British economy, and its decline will cause more difficulties in the London real estate market, up-market retailing etc. than will the equivalent decline in New York. Second, Britain has more or less hollowed out its manufacturing industry. We are already seeing some of the effect of US resilience this year; as the financial services business gets into greater difficulty and the dollar declines, manufacturing companies such as John Deere are able to take advantage of the weaker dollar and high commodity prices to expand their businesses at a rapid rate. Britain has few such opportunities.

Finally, Britain will suffer an additional recessionary effect from the “branch-plant” nature of its remaining financial services business. Asian finance is already moving increasingly to Asia, since London is in reality little more convenient than New York to carry it out. US finance, to the extent it has migrated to London, will migrate back to New York, since skilled staff will be available there in profusion as the business shrinks. Only the slow-growing EU and maybe some Middle East business will remain in London. However, other European financial centers and Dubai are keen competitors in those areas; to the extent the Middle East remains a viable economic region once oil prices decline, it will probably want to carry out its own financing, and the same will be true of the other major European countries. With few significant domestic institutions, London’s global market share is thus headed sharply downwards, reducing employment opportunities and revenues even beyond the effect of the shrinkage in the financial business generally.

Not only is it easy to see how the British economy could sink into a recession much deeper than in the US, it is difficult to see how it can emerge from that recession to renewed prosperity. Certainly a revival of London’s historic position as a financial services entrepot seems highly unlikely.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)