A new report by Paris-based economic think tank the OECD warns of a severe house price crash in the UK.

The report predicts that UK house prices will crash by 10% by 2010 and that, with consumer spending slowing, the Bank of England will eventually need to cut interest rates by three-quarters of a percentage point to 4.25% next year.

Ben Traynor in The Daily Reckoning explains how a house price crash in the UK will affect the country’s economy…

It never rains, it pours. Hot on the heels of the Bradford and Bingley saga, we wake up today to the news that mortgage lending has hit a record low.

Just 58,000 loans were made last month. That compares with 64,000 in March and 113,000 in April 2007. House prices will keep falling. But they’ll take their time — the market is drying up, with many would-be sellers pulling out of deals rather than dropping their prices.

It’s like a massive staring contest between buyers and sellers. Who will blink first? My money’s on the sellers — once they realise prices aren’t recovering any time soon, they’ll bite the bullet and drop them. Just a little bit… Then a little bit more…

So what’s the upshot for the housing market? A ‘soft landing’ or a short, sharp shock? And what about the economy?

Let’s start with housing. Fundamentally, houses are too expensive. But it’s hard to say how far and how fast they’re going to fall.

It all comes down to affordability. In theory, it should be easy to calculate the ‘correct’ level for house prices. How much do people earn, and what multiple of that can they affordably borrow? Run the numbers, and you get an idea of where house prices ‘should’ be.

But here’s where it gets tricky. We can get wage data pretty easily. But many would-be buyers have other capital to draw on. First-time buyers regularly rely on borrowing from parents, for example.

And besides, many current homeowners have demonstrated they’re all too willing to buy at a price considerably above what they can afford. Who’s to say the rest have learned from their mistakes?

Both of these factors make it hard to say exactly how far house prices need to fall to be ‘affordable’. But the good news, from our perspective, is that it doesn’t really matter. We’re confident we know which way they’re going, and that tells us a lot when it comes to where we should (and shouldn’t) invest.

Let’s move onto the wider economy. If house prices are coming down slowly, does that mean a ‘soft landing’ for the economy too? And is this preferable to a short, sharp shock?

Again, I think it’s going to take its sweet time sorting itself out. And here’s the kicker — the longer it takes, the greater the likelihood of a recession. I’ll explain why in just a second.

First, I want to answer the question of which we should be rooting for — the gentle decline or the brutal shock. My terminology is deliberately chosen to reflect the way I suspect the Government will view it.

The argument against a short shock can be summarised in one word — hysteresis. Hysteresis is the economic phenomenon of path dependency. A shock, so the argument goes, sets in train a series of events that can become self-sustaining.

An example would be long-term mass unemployment. If a large number of people are put out of work in one go, not all of them will find alternative employment quickly. Those that don’t will become deskilled, demotivated and will find it harder to get back into work. The shock, therefore, delivers its own persistent structural problem.

I think this argument has a lot of merit. But I still believe facing the inevitable, and quickly, is the preferable course of action. It all comes down to our irascible, temperamental friend Sentiment.

The longer this uncertainty drags on, the more entrenched negative sentiment will become. This will make a recession not only more likely, but more difficult to get out of.

Sadly I reckon this is exactly the scenario we’re facing. A long, drawn out recession. A few false dawns, with everyone, their confidence battered, scurrying for cover again at the first wobble.

The investment lesson is clear. Avoid companies with a high level of exposure to the British consumer. This would include most banks and retailers.

Put your money with firms whose profits aren’t wholly dependent on the spending habits of Mr and Mrs UK.

Because Mr and Mrs UK are about to go into hibernation…