What is holding back the British economy? Why is UK output still 3 per cent below its pre-crisis peak, more than four years after the start of the Great Recession, while other high-income peers such as the US, Germany and France have all recovered that lost ground? A growing number of economists have begun to converge on an explanation for our outstandingly feeble performance: debt.
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Britain, we are told, was more leveraged than other countries going into the crash and has thus struggled more on the way out. But what sort of debt, and whose? That's where things get contentious.
At a speech in Wales last month the Bank of England's Governor blamed the massive debts run up by the UK's outsize banking sector. Sir Mervyn King argued that the banks' relentless deleveraging since the 2008 crisis has held back the flow of lending to British households and businesses. He also strongly hinted that – even with the new Funding for Lending scheme providing a "powerful incentive" for them to make more loans available – the weakness in credit provision was likely to persist because the banks held insufficient capital.
But there is a contrary view on why debt matters. Danny Gabay, the director of Fathom Consulting, has argued that the primary constraint on recovery has not been high bank debt, but rather high domestic household debt levels which have restrained consumption.
Mr Gabay argues that house prices are being artificially sustained by forbearance from the banks for those struggling to keep up with their mortgage repayments. While that's good news for the people who are not being turfed out of their homes, it is, says Mr Gabay, preventing a general correction in house prices which, although painful in the short term, would create the conditions for national growth to take off.
The Fathom solution is to force a correction by getting the Bank of England to take mortgages off the books of private banks at a discount. "Such a policy would force the housing market to clear by establishing a floor for house prices. It would simultaneously relieve the commercial banks of their non-performing loans, and enable them to start afresh" Mr Gabay says.
So who is right? Do we have zombie banks or zombie households?
Let's consider the evidence. There was a large build-up in both banking and household debt in Britain before the 2008 crisis. Total banking sector assets (and liabilities) ballooned to 350 per cent of UK GDP (see the first chart above). And in the decade before the crash UK household debt as a share of income shot up from 100 per cent to 170 per cent (see second chart).
Ben Broadbent, Sir Mervyn's colleague on the Monetary Policy Committee, has pointed out that it was the banks' overseas balance sheets that exploded, not their UK books. And 75 per cent of their total losses were on foreign assets (all those US subprime loans packages). Mr Broadbent argues that as these global UK banks have pulled in their horns, they have also been forced to put a big squeeze on credit to British households. Thus, in his eyes, the UK credit crunch is largely imported and there is room for growth powered by domestic borrowing and spending.
The Bank also points out that institutions that are better capitalised (such as HSBC) have lower funding costs, implying that credit would be cheaper and more readily available for businesses and households if banks raised more equity.
Yet there is some strong evidence on the other side too. Research by the International Monetary Fund in April found that the Great Recession was more severe in economies, including Britain, which experienced a large build-up in household debt prior to the crisis. And despite several years of deleveraging by British households, the debt-to-income ratio remains elevated, at around 150 per cent. That's still higher than was seen in the US when their property bubble went pop. And the Bank of England itself estimates that some 12 per cent of UK mortgages are in some state of forbearance.
So the side of the fence on which you descend in this debt debate will, largely, depend on your view on the UK housing market. If house prices look reasonable, the problem becomes one of zombie banks. If house prices look inflated, the problem is zombie households.
It's a difficult call. Average house prices are very high compared with average incomes. Yet there are also serious constraints on supply in Britain – with house completions touching historic lows – which would justify higher prices than other countries. The Office for Budget Responsibility, for its part, does not expect house prices to fall.
What should be done then? In a sense it doesn't matter because nothing will be done. Fathom's idea of effectively crashing the housing market to bring on a general economic catharsis, even if it were desirable, is not going to happen. It would require the Government and the Bank of England to take a view on what the "fair" level of house prices should be. Even if the authorities were willing to do this, how would they go about deciding what that level should be?
And cleaning up the banks' balance sheets, regrettably, looks impossible too. Regulators have been telling the banks to raise their capital levels (rather than merely their capital ratios) for years, but the sector has simply ignored them.
If the debt burden is indeed what is holding down our economy, there seems little prospect of it being lifted. Given this extreme uncertainty, my view is that our best policy guide is Richard Koo, of the Nomura Research Institute, and an expert on Japan's post-bubble economy. Mr Koo argues that while the private sector (no matter which part of it) is deleveraging in the wake of a large bust, the public sector must step in to sustain economic demand to avoid a downward spiral. And this means fiscal and monetary activism – for as long as it takes.