Debt has a bad name. But while there are clear risks associated with living beyond our means, there are also potential benefits associated with borrowing.
Debt enables us to own our own homes, start or expand a business, and finance training or education that boosts earnings later in life. In fact, there is a well-recognised life-cycle within which the young borrow to finance consumption, the middle-aged save and accumulate assets, and the old dis-save.
Indeed, my own youthful borrowing included buying my late wife a grand piano on an overdraft, a decision that underpinned 33 years of happy marriage. (And I paid off the debt after a struggle.)
The issue with debt is one of limits and sustainability, for both the individual and the wider financial system. The same, clearly, applies to government debt and corporate and financial sector leverage.
What the 2008 financial crisis and its aftershocks have taught us is that those limits may be closer than we think – and, once crossed, can lead to rapid and painful corrections.
A loan for a dog?
Prior to the late 1990s, the share of household debt as a proportion of household income in this country was largely stable, sitting somewhere between 90-100 per cent. It then rapidly grew as credit conditions eased and lending standards weakened, reaching a peak of 160 per cent in 2008 just as the financial crisis hit. I achieved some fame by warning about the credit frenzy, epitomised splendidly by RBS offering a £10,000 unsecured loan to a borrower who turned out to be a dog.
While the crunch may have been initially triggered by British banks’ exposure to US subprime debt, elevated domestic household debt magnified the downturn.
As the economy weakened, hitting jobs and wages, indebted individuals chose either to default or cut spending, further reducing demand and worsening the crisis. According to the Bank of England, this dynamic explains half of the drop in consumer spending after 2007. The phenomenon, described a century ago by Irving Fisher as “debt deflation”, explains the use ever since of aggressive cheap money policies.
Ultra-low interest rates are now feeding a new round of borrowing. Despite falling in the wake of the financial crisis, household debt as a percentage of GDP remains high at 142 per cent and is rising fast. Of the G7 countries, only Canada ranks higher than the UK.
The Brexit effect
What’s more, the Office for Budget Responsibility predicts it reaching 153 per cent by 2022. But this estimate may prove conservative since, in the wake of the Brexit vote and the pound’s subsequent devaluation, weak growth and falls in real wages mean that living standards are being maintained through personal borrowing, which has risen 10 per cent over the last year.
Optimists would accuse me of scaremongering, given the asset side of the household balance sheet looks healthy. Mortgage debt accounts for around 90 per cent of the total, and asset prices have boomed such that the housing stock is worth roughly five times mortgage liabilities. No problem, then?
Well, not quite. As is usually the case, the problems are on the margins rather than in the averages. Recent Bank of England figures show unsecured debt (credit card spending, personal loans) growing at four times the rate of mortgage debt, while the household savings ratio has fallen to its lowest level on record.
Within mortgage debt itself, the IMF has picked up on a worrying number of new mortgages with high loan-to-income ratios, leading it to conclude that “such high leverage significantly exposes households and banks to interest-rate, income, and house-price shocks”.
Debt vs. growth
I personally suspect that, after more cautious regulatory policy since the financial crisis, the banks are safe. But many individuals, especially the young and poor, are potentially exposed to serious distress as the economy slows further and interest rates eventually rise.
The key risk we face is that growth becomes almost wholly dependent on debt-driven spending, rather than intelligent, long term investment. Although unemployment is historically low, and growth (until recently) has been respectable, the UK faces deep problems reflected in low and falling productivity, stagnant real wages, and regional inequality.
By artificially propping up consumer demand, debt has kept our economy going while delaying the urgent need to boost investment and innovation.
This cannot, and should not continue any longer – it is time now to put our economy on a more sustainable footing.