The U.S. National Association of Homebuilders Housing Market Index jumped to 46 on Monday, its highest level since May 2006, just before the peak in house prices. In Britain, especially in south-east Britain, house prices remain inordinately high in terms of wages, rents and purchasing power. In the United States house prices are subsidized by innumerable tax and other benefits, including an effective government guarantee of most home mortgages. In both countries, house prices are subsidized by interest rates that have been inordinately low for over four years. In both countries, government budget deficits threaten the stability of the financial system and the economy generally. Overall, it’s time to put housing policy into reverse and to reclaim some of the subsidies from the housing sector.

Housing subsidies are largely a product of politicians’ sentimentality. In both the United States and Britain before 1980, house prices were affordable in terms of average incomes and housing finance operations like Jimmy Stewart’s Bailey Building and Loan (“It’s a Wonderful Life,” 1946) made mortgage loans to middle income people who had saved a sufficient down-payment. It’s likely this idyll could have continued forever but for the inflation of the 1970s, which caused interest rates to rise in both countries so that in Britain mortgages (which generally carried floating interest rates) became unaffordable and in the U.S. the losses on fixed-rate mortgages destroyed the balance sheets and cash flows of the savings and loan associations.

The inflation of the 1970s also affected the public’s attitude to housing. In both countries, houses ceased being simply places to live and became investments. From this point, the better-off ceased worrying about the upkeep costs of a large house and began to extend themselves in the mortgage market, hoping to maximize their investment profits. The result was a massive run-up in prices in fashionable areas like London, New York and most of California, which took both housing and local jobs well out of range of ordinary people. I am by most standards quite wealthy, at least in terms of income, but I could no more afford to live comfortably in today’s London than I could afford a luxury yacht and its attendant upkeep and crew.

The ideal we should aim at is Germany, where thanks to the admirable Bundesbank there has been little inflation, so home ownership is limited. Only around 43% of the population owns a home and finance is available for at most 80% of the purchase price, normally less. German house prices have been flat or slightly declining in nominal terms for two decades, and only recently, as euro monetary policy has been by German standards excessively lax and euro interest rates have been held down below German inflation, has there been a bump of maybe 10-15% in prices.

It’s not a coincidence that Germany has the most successful industrial sector in Europe. Because of its lower house prices less of its savings are wasted in home purchase, even though the rich, like the Victorian British, are substantial investors in rental properties. (They invest little in equities, substantially in bonds and not at all in hedge funds or other worthless excrescences of the Anglo-American capital markets.) Houses are affordable, either to buy or to rent, yet staff are mobile when they are needed to be, since only the oldest and longest established own their homes.

In short, the German housing and house finance market is a good template, and our policies should be aimed at mirroring that market.

In the United States, the home mortgage interest tax deduction should be abolished, providing a sizeable $60 billion annually towards closing the $1 trillion Federal budget deficit. If as is likely a populist President and Congress wimp out of most of the tax increases in the “fiscal cliff,” abolishing the home mortgage interest deduction will at least provide a modest move towards fiscal sanity, even though that particular tax break is not as egregious as the “carried interest” treatment of private equity profits or the tax break for charitable donations, both of which actively encourage economically destructive behavior.

The most egregious housing subsidy in the U.S. system is the effective Federal guarantee of home mortgages through Fannie Mae and Freddie Mac. This grew up almost accidentally, resulting from the development of mortgage securitization techniques in the 1970s and 1980s. It has resulted in the death of the Jimmy Stewart model, and its replacement by a gigantic bureaucracy, which makes the mortgage process far more difficult than it needs to be.

In addition, the Federal Housing Administration guarantees mortgages itself, a duplication of effort if ever there was one, and has exhausted its capital, having loosened its lending restrictions in 2008 just as everyone else was tightening them. The FHA now supports 15% of all mortgages, up from 5% in 2008, and its stated purpose of enabling the indigent to get mortgages has been stretched to include a maximum guarantee limit of no less than $729,000.

We were informed this week that Fannie Mae has expanded its staff by over 1,000 since its bankruptcy in 2008, although Freddie Mac has cut back slightly. In addition a nominal 15% decrease mandated by Congress in the value of mortgages bought directly by the entities has been effectively ignored.

This subsidy has gone on long enough. With housing recovering, these entities need to be shut down, not over a period of a decade or more but within a year. The U.S. banking system is eminently capable of making home mortgages itself, as it did for decades before 1970, and if the cost of housing finance increases somewhat, so what? It will push people towards lending and away from excessive leverage, both favorable developments for the overall economy.

There are other subsidies that also need to be removed. Under the Basel banking regulations, mortgages are given preferential; treatment in banks’ capital calculations compared with other loans. Experience since 2006 worldwide has shown the risk assumptions behind this to be faulty, as are the even more egregious subsidies given to holding government paper. Changing this is simple; the housing sector does not deserve such consideration.

The final subsidy to remove is that of ultra-low interest rates. These favor investment in long-term assets of limited volatility, such as home mortgages, thereby allowing banks to load up on mortgage assets on a highly leveraged basis while neglecting the far more economically valuable activity of lending to small business. Low interest rates have de-capitalized both the United States and Britain; they have also driven British house prices up to inordinate heights, and will do so again in the U.S. if the current housing recovery is allowed to fester.

Remove these subsidies, and house prices in Manhattan, the fashionable bits of California and South East England will collapse, halving or more in the Russian Mafia-dominated purlieus of central London. That will have a number of beneficial effects. It will cause losses to the more foolish and spendthrift rich, who have overinvested in housing. It will deter young successful people form overinvesting in housing, thereby increasing their investment in equities and especially small businesses. At a less exalted level, it will remove the bias between renting and home ownership, thereby increasing workforce mobility, so that families will tend to buy houses only when they are well established with children, perhaps in their 40s.

Naturally, to get Germany’s housing market, the authorities in Britain and the United States will need to adopt Germany’s monetary policy (or rather, that of the Bundesbank before 1999.) For Britain, this will not be all that difficult; the traditions of the Bank of England include the wholly admirable Montagu Norman and Rowland, Lord Cromer. While there are few if any of the current staff left from the period of those worthies, there is at least no institutional bias against sound money.

In the United States, it will be more difficult. Paul Volcker lasted only eight years and was immensely lucky; one can imagine the fate of his sound policies when matched against a President George W. Bush rather than Ronald Reagan. The legislation governing the Fed needs rewriting, with the “dual mandate” to cover unemployment removed, and provision made so that Fed policy is adequately “Volckerized” in spite of political pressure. Mere independence is not enough; we have seen in the past few years the damage that can be done when an independent Fed is run by a Chairman more populist than Huey Long. Historically, however, even the Gold Standard Fed of the 1920s proved prone to meddling in the wrong direction, creating a surge of speculation in the 1920s followed by an orgy of debt deflation in the early 1930s. Criteria must be set so that future Fed Chairmen are forced to govern by monetary policies that mimic a true “free banking” Gold Standard, in which money creation is automatic and central bank policy meddling minimized.

That’s for the long term, and after this month’s election results not immediately feasible. However, removing the multiple egregious subsidies to housing is currently feasible, and forms a major element in the lengthy and difficult task of restoring the U.S. and British economies to full health.

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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.)