Floating on a sea of debt

by David Smith
September 7, 2003, Sunday


DEBT has become the issue of the day. Households are borrowing as if there is no tomorrow. And the government, facing a shortfall between its appetite for spending and slower-growing tax revenues, is holding out the begging bowl.

You don't have to be Shakespeare's Polonius - "Neither a borrower nor a lender be" - to wonder whether there is something dangerous and unsustainable about all this.

The New Economics Foundation, in a scary book, Real World Economic Outlook, is alarmed and is predicting doom and disaster for the middle classes.

"Gullible consumers, acting as heroically as Atlas once did, are holding up the US and UK economies by dutifully borrowing and spending," says Ann Pettifor, the editor.

"But take-home pay is falling in the UK and unemployment is up in the US, so consumers will soon buckle under the strain of single-handedly propping up these economies. As we live in a deflationary era, the burden of debt will be more painful than it was, say, during the aftermath of the Lawson boom.

"When the tipping point is reached and the credit bubble bursts, it is the middle-class debtors who will bear the full brunt of a debt- deflationary financial crisis."

There is quite a lot to challenge in that diagnosis. But first let's look at some numbers. Bank of England figures last week showed that households borrowed another Pounds 9.9billion in July, up 14% in 12 months.

Households are now carrying debt of Pounds 888billion, equivalent to 124% of annual disposable income. At this rate of increase, debt will top Pounds 1,000billion next summer.

Meanwhile, Gordon Brown's borrowing is also rising sharply. Taking this year and the next three together, the Treasury's own forecasts are for net borrowing of almost Pounds 100billion. Independent economists expect Pounds 130billion to Pounds 150billion or more. Whether by government or by households, that's a lot of borrowing.

The first question is whether today's borrowing feast will be followed by a famine. There are signs of that already as far as the government is concerned.

The Treasury has warned Whitehall departments that they should enjoy the largesse while it lasts, because the brakes are about to go on after the current three year spending review period ends in 2005-6.

For households, there is also an official warning from Paul Tucker, Bank of England executive director in charge of markets and a member of the monetary policy committee. He has cautioned that people may be taking on debt on the basis of unrealistic expectations about interest rates and future growth in incomes.

Interest rates, he said in a recent speech, were below their long-term average.

Real income growth was likely to be weaker than in the past few years. Tucker's reminder that 3.5% rates are unusually low was useful. A normal or "neutral" level of rates is nearer 5% than the current inflation target - although there's an element of catch-22 in this.

Barring accidents, such as an unexpected inflation shock or a sudden dive for sterling, interest rates will rise only when the Bank is convinced that the prospects for growth have improved. That, in turn, should be associated with stronger growth in employment and incomes, making debt easier to service, even at higher interest rates.

Despite higher borrowing, the servicing of debt is still quite comfortable for the vast majority of households at current interest rates. Most of the problems reported by Citizens Advice Bureaux are among people with poor credit ratings who have borrowed at high rates.

It would take a doubling of interest rates to produce anything like the strains of the early 1990s and that is not remotely in prospect. While debt is rising strongly, it is dwarfed by household assets, which stand at seven times income. That does not mean we should be comfortable about 14% annual borrowing growth by households. But it means we should not panic.

There is, though, a second question about debt. If households and the government are borrowing hand over fist, who is doing the lending? Are we badly in hock to the rest of the world?

The answer, surprisingly, appears to be no. Britain's current account deficit last year was less than Pounds 10billion and there was actually a surplus in the first quarter of this year.

These figures are subject to revision because of a fraud that resulted in an under-recording of imports. Even so, they will not paint a picture of a balance of payments lurching violently into deficit. In simple terms, the government and consumers are able to borrow because companies are in a position to lend. The corporate sector is running a financial surplus - 2.5% of gross domestic product over the past year - that more or less balances the financial deficits of households and government.

This is not necessarily good news. It would be better for the economy's long term health if companies were using their cash to invest rather than channelling it to consumers and Whitehall departments for less productive purposes.

In a purely financial sense, however, there is not yet a problem with imbalances.

The private sector - companies and individuals combined - is in overall surplus; the public sector is in deficit.

This sets Britain apart from America, where debt worries are also at the forefront of concerns. A new paper from UBS, Debt Trap, lists some of these worries. Unlike Britain, America has a triple deficit problem. The public sector, private sector, and most spectacularly the current account, are heavily in the red.

UBS predicts a budget deficit of $ 500billion (Pounds 320billion) next year, alongside a current account deficit of more than $ 625billion (Pounds 400billion).

Not only are America's imbalances growing, they will continue to do so. With the White House happy to see a big budget deficit as a price worth paying for George Bush's re-election, America has no option but to borrow.

This strategy appears to be paying dividends in growth. The main feature of recent days has been renewed optimism about global recovery, led by developments in America. The message of the imbalances, however, is that the United States cannot go it alone. As UBS puts it: "The US-led expansion cannot persist in the medium term. The US cannot increase private-sector debt indefinitely. It cannot increase government debt indefinitely and it cannot increase external debt indefinitely."

Bush isn't the first politician to be faced with a choice between clearing up his own economic mess and bequeathing it to his political opponents. Tony Blair should be working hard to ensure that in a couple of years he isn't in the same boat.

PS: Now is a good time to revive the skip index, my indicator of economic activity based on the number of builders' skips in my street. When there are none, we're in recession. When there are six, it is a fully-fledged boom. The number has crept up to four in the past week or so, pointing to a strengthening of the economy also evident in other data and surveys.

The monetary policy committee (MPC) did not have access to the index when deciding to leave interest rates unchanged at 3.5% on Thursday. The tone of the meeting must have been very different from recently, however, and it will be interesting to see when the minutes are published whether any members voted for a rise.

The markets are mindful of what happened in 1999, when the Bank cut rates in the summer but raised them in the autumn. A repeat is possible: indeed, a rate rise last week would not have been a huge shock.

The real lesson, however, is that these things can change quickly.

A couple of months ago the Bank was cutting rates. Now everybody expects them to be raised because of an outbreak of growth optimism.

I am always inclined towards optimism but the current sunny mood may not be maintained. Rates look to be on hold for some time.

david.smith@sunday-times.co.uk