The household debt bubble won’t grow forever

By New Economics Foundation: Mark Carney, the Governor of the Bank of England, has changed his mind on household debt. In January he said it was just an indirect threat to the economy, but asked again on Sunday he warned that rising levels could make a recession much more severe.

His change of stance isn’t without good reason. New data from the Bank of England shows that households are borrowing at a rate seen just before the financial crash in 2008 – and the government’s own forecasters think it’s only getting worse.

The below graph is taken from the Office for Budget Responsibility’s (OBR) latest economic forecasts. It shows that within the next five years household debt, relative to income, is also predicted to increase to levels last seen just prior to the financial crisis:

Household borrowing continuing on this scale would be unprecedented in recent history, according to the OBR.

So what’s going on here?

In the economy, total income equals total spending: every pound spent somewhere is earned somewhere else. So if one sector of the economy is spending less than it’s earning and saving, the other sectors must collectively be spending more than they’re earning, and accumulating debt or running down savings.

After the financial crisis in 2008, households started spend less to pay down debt, so the government spent more and ran large deficits to offset the effects of the crisis.

But with the government pursuing further cuts to public spending in order to achieve a budget surplus by 2019-20, the only way that growth can be achieved and consumption maintained is by households running down savings and accumulating debt. This is exactly what the above chart from the OBR shows.

Increasing household indebtedness has meant two key things:

1. Mortgage debt has continued to rise as house prices have grown more quickly than incomes

With UK house prices already nine times average incomes – a consequence of financial deregulation, ill-thought out planning and housing policy – this is a worrying sign. Mortgage debt cannot keep on growing forever relative to incomes. At a certain point people will become unable to support debt repayments, at which stage we risk mortgage defaults, falling house prices, recession and, potentially, a 2008 style financial crisis. This could be accelerated by an economic shock – for example, a sudden rise in interest rates, making the cost of borrowing higher.

2. The UK economy has become increasingly reliant on household consumption spending, driven by risky borrowing

With wages failing to keep up, households have only been able to increase consumption by borrowing more in total. Underpinning this has been a rapid increase in unsecured consumer lending – credit cards, overdrafts and other forms of consumer borrowing such as payday loans. Unsecured lending can act as an early indicator of a return to unsustainable growth: credit is relied on to create growth when real wages are not high enough on their own to drive spending.

The below chart, from the Bank of England’s Statistical Release for March, shows changes in unsecured consumer credit since 2013:

The 9.7% increase in unsecured consumer credit over the past twelve months represents the fastest growth in a decade. This isn’t good news: millions now rely on a debt safety net for everyday expenses.

As Carney highlights, relying on household borrowing only creates problems for the future. It might boost spending for now, but will ultimately squeeze people’s ability to spend – even on basics – as is likely the case for 3.8 million individuals who currently spend more than 40% of their income repaying debts.

And it restricts the Bank of England’s options for managing the economy: raising interest rates to try and encourage more saving and less borrowing for spending will cause millions of people to default on their existing loans.

We need to reduce debt – but how?

In 2014 an ambitious campaign resulted in a cap on payday loan charges, which helps restrict the extent to which people can get caught in a debt spiral. Yesterday the Competition and Markets Authority released guidance  recommending banks cap fees on unarranged overdrafts and provide warnings to account holders that they are about to dip into negative on their accounts. Regulation could be extended to other forms of high-cost lending such as credit cards, home-collected credit and rent-to-buy.

The government could do more to offer alternatives to high-cost credit. In Australia, the National Bank and the government worked with a microfinance organisation to set up a scheme that offers no-interest loans to people who struggle to access cheap credit elsewhere.

Most government action is focused at helping individuals save, but is ineffective for those on the lowest incomes who are most in debt.

This bigger picture is this: we need effective social support and higher wages so people don’t rely on credit, and to stabilise the housing market in order to slow the mortgage debt bubble.

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