Yesterday The Telegraph reported on the current house price boom. The average asking price in England and Wales is more than £262,500 – 7.3% higher than it was 12 months ago. For those of us who struggle with the concept of cumulative growth 7.3% doesn’t sound like a very big number but if you do the sums a 7.3% annual growth rate means house prices will more than double in 10 years. By 2025 a two-bed semi in Averagetown will cost you a cool £530,000.

The Telegraph article wants us to believe that rising house prices are all to do with the laws of supply and demand: there are more people wanting to buy houses in certain parts of the country (e.g. London) than there are houses for sale, so the prices go up. This is a classic example of economic analysis missing the point because it ignores the key ingredient in the mix: money.

Where does the money come from to pay for these rises in house prices? It certainly isn’t coming into house buyers’ pockets via increased wages and salaries, nor is it the result of increased economic activity. Growth in wages and GDP have both been feeble in comparison to the growth in house prices.

The vast majority of the money that is used to buy houses is created out of thin air by the banks when they issue mortgages. Increases in house prices are fuelled by increases in the creation of money as debt by the banks. Sure, if lots of people want to move to a particular location and there aren’t enough houses to go around then that will push up prices, but this can only happen if the banks create the extra money that’s needed to pay the higher prices. If you remove the extra money from the equation the prices cannot rise.

If we want to reach beyond simplistic notions of supply and demand and understand why property booms happen the next question that we need to ask is “where does the money go?”

Some of the new money is used to pay off existing mortgages, which means that it gets destroyed in the accounting systems of the banks. Some gets stuffed into savings accounts, but much of the new money enters the economy as deposits on house purchases, fees for estate agents and solicitors, or it gets spent on home improvements, new furniture, holidays, and the like.

In the short term we all benefit from these increased flows of money around the economy. More people have more money to spend which means businesses need more people to work for them. More tax gets paid, which means the government can reduce the deficit or provide more public services and boast about its economic competence. This is why the current government is encouraging people to take on mortgages (Help to Buy) and has been desperately trying to encourage banks to lend by throwing money at them (quantitative easing).

Of all of us it is the bankers who benefit most from a property boom. With every new mortgage they create new money and immediately take a chunk of it for themselves (arrangement fees). Every month they get to keep a little bit more of the money that they created (mortgage interest). The increase in economic activity that’s been fuelled by the new money means that they capture even more it from their business customers (bank charges). And all of this extra income can be used to gamble on the financial markets, which gives them more opportunities to charge fees and cream off a percentage of the winnings.

In the short term everyone benefits from a property boom. So what’s not to like?

The problem is that the money that’s fuelling the boom has been created as debt, which has to be repaid. When the principal (the original amount of the mortgage) is paid back the money is destroyed in the accounting system of the bank. So the money that floods the economy to create the boom is constantly being drained out of the economy long after the lending/spending spree has fizzled out.

Our obsession with capturing and hoarding money makes the problem worse. Banks suck money out of the productive economy in the form of interest payments, businesses suck it out as net profits, and individuals suck it out as savings. Much of this money never returns to the productive economy. Some of it gets used for financial gambling (betting on the future prices of shares, commodities and the like) or just lies rotting in bank accounts.

If the money that’s continually being lost to debt repayment, hoarding and gambling isn’t replaced then the economy will struggle. To keep the system working we have to continually add new debt to our existing debt, but the capacity of the productive economy to make loan repayments is finite. If we continue to borrow more and more money to keep the productive economy working the debt repayments will, at some point, overwhelm us and the whole thing will collapse around our ears.

Mainstream economists and journalists won’t tell you this because conventional economic theory ignores money, which means those who have studied economics struggle to understand the true nature of the bubble. It’s not a property bubble, it’s a debt bubble that’s being deliberately inflated by the government (because the flood of money makes us feel good in time for the next election) and the bankers (because debt is what makes bankers rich).

The gap between supply and demand for houses in some parts of the country is not the root cause of the rise in house prices, it’s merely a convenient way to inflate the debt bubble that’s at the heart of our insane financial system.

Happily, some economists, journalists, bloggers, and even a few politicians are starting to understand the insanity of the system and are exploring ways of making our economy work properly for everyone, all of the time. I just hope we get there before the debt bubble goes “pop”.