There Is A Household Debt Problem

Written by Dr. Vincent Cable MP and published in Liberal Democrats In Business on Tue 3rd Feb 2004

As the late Lord Whitelaw would have put it: the Bank of England is vigorously stirring up apathy about the issue of household debt. After warnings last October about excessive household debt the fears have been played down and Professor Stephen Nickell of the MPC has now produced a carefully argued academic analysis (Bank of England Quarterly Bulletin Winter 2003) putting the scaremongers firmly in their place.

Who are we to believe? The worriers, who now include the chairman of the City watchdog, the Financial Services Authority, point to record levels of household debt in relation to post tax income, now 120% as against 40% back in 1980. Four fifths of the debt is secured against appreciating house prices which, in relation to income, are at levels comparable to those just before the house price crashes in 1973/75 and 1990/1992 There is also growing evidence of debt distress in the form of record personal bankruptcies. The Bank's own analysis suggests that 10% of debtors regard debt as a heavy burden and 20% of those with unsecured debt are borrowing to service the loans.

The counter argument is that the debt to income ratio of the relevant group, i.e. debt holders, is not deteriorating; that the debt servicing ratios of households are at historically low levels (10% of post tax income as against 15% in 1990); and that the relationship between secured (mainly housing) debt and assets and between unsecured debt and financial wealth currently do not depart far from historical averages

But the Nickell analysis fails to consider the complications of some emerging trends in respect of the flow of new lending. Net lending to households has reached comparable levels to those at the peak of the Lawson boom. Wynne Godley has also drawn attention to the growing financial imbalances of the personal sector (the gap between household income and household expenditure).

In key respects both sides are right. The difference is not over current facts but over expectations of the future. The worriers emphasize that consumers are taking on debt on the assumption that employment will remain at recent high levels, interest rates will remain low, income growth will remain strong and house prices will remain high. The last three of these assumptions are already looking questionable in varying degrees.

What is confusing the debate is that there are two distinct debt problems. First, there is a minority of borrowers, mainly in low income households, who are in severe difficulty with debt. Analysis shows that the most serious problems relate to unsecured debt and families in social housing: a quite different problem from the home buyer borrowing over the odds to get a foothold on the homeownership ladder. Debt as a manifestation of poverty is a very real issue though - and here Nickell is right - it is not a macroeconomic issue. It does however call for action on several fronts. There should be easier access to genuine independent, costless, financial advice of the kind which CAB's offer on a modest scale rather than high cost and often unscrupulous commercial debt 'advice'. There should be access to emergency lending which is not exorbitantly costly, as some money lending often is and, in the absence of effective credit unions, the Social Fund could be restructured for this purpose. There has to be more effective protection from predatory loan sharks without either driving money lending into the criminal underground or relieving the genuinely profligate of the obligation to manage their financial affairs responsibly. None of these are easy or offer dramatic short term benefits; but, at present, little is being done at all.

The other debt problem is potential rather than actual. Continuation of comfortable balance sheets of households with big mortgages does depend on the absence of a serious crash in house prices plunging substantial numbers into negative equity. The optimists believe that house prices are being driven up by 'real' and enduring scarcities in the housing market caused by more people and more households chasing seriously constrained increases in the housing stock (this was the focus of the Barker report). And they believe that, barring some major unforeseen shock, policies designed to ensure financial stability will ensure low interest rates, low inflation and steady growth without a destabilizing 'boom and bust'.

The worriers however take a different view: that, while Gordon Brown's estimable commitment to financial stability may work in aggregate, there can still be 'boom and bust' in asset markets, of which, in Britain, housing is the most important. Just as stock markets see 'irrational exuberance' so do property markets. There is some evidence, acknowledged by the Bank of England, that some of the demand for mortgage credit is speculative in character prompted by expectations of capital gains no longer available in equities and by panicky first time buyers who would be better served by renting accommodation but fear being left off a house price escalator. The Nobel laureate Daniel Kahneman has demonstrated that home owners are likely to be overly optimistic about ever rising prices in a boom period.

On the lending side of the market, as Barclay's Matt Barrett has been frank enough to acknowledge, a few aggressive lenders are pushing loan to value ratios and income multiples into the hitherto uncharted territory leaving their more conservative competitors to follow suit or lose market share. These are the key ingredients in a potentially unstable asset bubble.

It will only be clear with hindsight who is right. What is clear is that there is no mechanism at present for dealing with asset bubbles and what happens if they burst. Interest rates cannot be used proactively since asset inflation (or deflation) is not part of the mandate of the Bank of England MPC (or the ECB) and the new inflation index does not even include house prices in its measurement.

Prudence demands some thought as to how a housing bubble and associated debt should be managed. At present the problem is being largely assumed away: But sooner or later the issue will have to be faced: if the prices of mortgage finance (interest rates) cannot be varied to reflect the state of asset markets, what other mechanisms are available? Should not the quantity of credit be a matter of concern to the monetary authorities?

The debate at this point tends to be closed down - too easily - by the assertion that the authorities no longer have any leverage over the amount of credit available. In liberalized markets, it is argued old fashioned credit controls no longer work. In competitive globalised markets, ingenious lenders are likely to be one step ahead of the regulators. Perhaps so, yet the position is not quite as extreme as it appears and is presented. Banks are required in any event to observe prudent reserve requirements under international (Basel) rules and by national regulators to avoid solvency risk. Both involve adjusting reserves to reflect the state of asset markets and therefore, the risks of loans. By their own accounts the leading banks are crawling with F.S.A regulators concerned with these problems and others (money laundering for example)

It does not require too much imagination to see how their remit could include a requirement for reserves of mortgage lenders to be adjusted counter cyclically or the establishment of guidelines for prudent lending in respect of, for example, loan to value ratios. Any intervention by the Bank of England or the FSA would have to be guided by an independent and expert view of the asset market by a body analogous to the MPC: a technically very tricky issue but one which could be informed by good modeling and analysis. It would not be necessary to estimate as precise as the equilibrium price of housing but to make judgments as the likelihood that the market is over or undervalued. The framework sketched out above clearly requires elaboration and debate. At present there is none.

To these two, distinct, debt problems should perhaps be added a third. Current house hold savings are simply too low to promote a satisfactory long term flow of income for retirement in an ageing population. Poverty beckons for millions, or else unsustainable demands on the state. Estimates of the savings 'gap' vary, but the National Institute figure of around 5% of GDP is plausible. Whatever view we might take of the immediate, short term, problems presented by household debt, net borrowing - dissaving - is too high. The market mechanism to correct this imbalance is an overall long term increase in interest rates (which will of coarse make servicing outstanding debt more onerous). The point is made by some analysts that, for this reason, current interest rates are around 2% below equilibrium levels.

There is also an argument to the effect that there is an institutional bias against saving. The degree of regulation surrounding personal investment - from health warnings to the complex box ticking required of financial advisers - is not matched by regulation of debt promotion. Banks and credit card companies aggressively solicit new lending business; the recent offer of a £10,000 loan to a dog captures the carelessness, indeed recklessness, of the lenders. At the very least one would expect debt promotion and the sale of investment products to be roughly neutral in their treatment. They are not.

It is possible that continued economic stability, a gradual spontaneous adjustment in household balance sheets and a 'soft landing' in the housing market will, together, remove anxiety about household debt. But, it is the job of policy makers to prepare for worst case scenarios as well as the best.