There have been lots of explanations offered for why a fall in land prices affects the wider economy, which is like the tail wagging the dog. It is ultimately the health of the economy which dictates land rents, which adjusted for interest rates dictate land prices.
Some people talk vaguely about "the wealth effect" or "animal spirits" or "financial contagion" in the vaguest sense, in which there is some truth but those are very simplistic and superficial concepts.
The way I understand it, it is a simple mechanical thing that follows automatically from the way banks work. It illustrates the old adage that "If you owe the bank £10,000 it's your problem, if you owe the bank £1 million, it's the bank's problem."
As we know, an average UK bank's assets are 80% loans on land and 20% short term loans, overdraft facilities, HP agreements, credit cards etc. The bulk of their liabilities are customer deposits.
When the land price/credit bubble finally pops, as it does every 18 years or so, people will want to withdraw money from the riskiest bank, i.e. the one whose assets are 99% loans on land and which has been handing out the highest loan-to-value mortgages e.g. Northern Rock. People withdraw money from NR and short of stashing notes under the bed, all they do is swap a deposit with NR for a deposit with a safer bank or with the government e.g. NS&I.
Duly panicked, depositors with the second wobbliest bank will want to withdraw their money on the assumption that it will pop next. That bank of course can't call in much of the 90% of its loans that are on land any faster than the underlying loans and interest are going to be repaid; the borrowers simply can't pay any faster. The banks don't want to do mass foreclosures on land which is falling in value because that would be a vicious spiral, so where do they get the money from to repay the depositors who want to withdraw?
The only ways they can get money back quickly are (a) cancelling people's overdrafts or (b) stopping their credit cards and demanding repayment in full (or not making any more personal loans).
a) I look at dozens of balance sheets every week when I'm doing tax returns, and it is quite normal for a business to finance its entire stock of goods with an overdraft. That stock of goods has a turnover period of a few weeks or months, so the bank can get its money back as quickly as the goods can be sold. By doing this, the bank has bitten the hand that feeds. When those goods have been sold and the overdraft repaid, the business will find it difficult to stay in business because it can't finance more purchases. Some will survive by scaling down, others will go under.
b) If people stop spending on credit cards/personal loans, clearly there will be less spending on goods and services for several months until all the debts are cleared and people have saved up for what they otherwise would have bought with a personal loan.
Put (a) and (b) together, we see that the productive economy is being sacrificed on the altar of the land price/credit bubble. These two effects reinforce each other of course; once a business has had its overdraft cancelled and demand for its output is falling, it will find it hard to refinance with another bank; there are knock-on effects on its suppliers. So people lose their jobs, there is less spending and less demand etc etc.
Obviously, the best answer is always shift taxes from production to land values, as a second best, the answer must surely be to segregate banks into
a) hmm, let's call it "Building societies" who lend only on land and whose depositors face strict withdrawal limits i.e. they can't withdraw any faster than borrowers are paying in, so a "deposit" with such a bank is more like and annuity. So even if their depositors all panic, it doesn't affect credit availability for proper businesses, personal loans etc, and
b) ordinary commercial banks who are only allowed to lend short term to businesses to finance working capital and fixed assets, to grant overdrafts, credit cards, personal loans etc.
Lending between banks and building societies would be strictly verboten, of course. This surely makes far more sense than some arbitrary and meaningless split into "retail banks" and "investment banks".
Rather perversely, there is an inverse relationship between the savings rate (i.e. deposits) and house price increases, so actually, during such a period, the banks should have more money from depositors to lend to the productive economy, but somehow it doesn't work like that. I suppose because once the land/credit bust has infected the real economy, banks are just too cautious and stick all the money into government bonds or something.
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I cheerfully admit that this might all be old hat and a widely accepted explanation in some circles (not that I've ever read it anywhere). Possibly I have missed the point and there is a better explanation, so I'm open to suggestions, but AFAIC, it is as simple as that.
Debate Magazine
