Economic View: After the debt, the grind

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The Independent Online

Worried about your debts? You shouldn't be - or at least you shouldn't be too worried, if a new report on household debt by the economics team at Barclays Capital is right.

Debt is of course a hugely important issue. It is important at an individual level: young people getting on to the housing ladder are borrowing five or more times their salary. Graduates leave university with an average debt of some £10,000, and top-up fees will cause this to rise to £21,000.

And it is important at a national level. The economy is supported by a consumption boom, which in turn has been supported by the borrowing boom. The last similar lending and spending spree, in the late 1980s, ended in misery in the early 1990s, with that strange expression "negative equity" gaining currency. Why should the present boom be different?

Where to begin? Well, I suppose the first thing to be clear about is that there has indeed been an enormous surge in borrowing and that there is indeed a link between that borrowing and the consumer boom. The first two graphs above show the surge in personal borrowing as a percentage of after-tax income and the relationship between growth in consumption and equity withdrawal (people borrowing against the value of their home to spend on something other than a house purchase).

The first one shows the two elements of the present borrowing boom: a jump in mortgages and a jump in credit card debt. The latter is much smaller but is often at very high interest rates. The cost of servicing mortgages is much lower than it was in the early 1990s, when interest rates were more than double their present level, whereas the cost of paying off credit cards is only a bit lower. But the plain fact remains that total household debts are larger than total household income.

Now look at the way borrowing is supporting spending. The second graph shows the parallel between the surge in equity take-out in the late 1980s, peaking at about 8 per cent of income, and the present surge.

Add in other disturbing statistics, such as the level of individual insolvencies, which are running at the same rate as in the early 1990s, and it is not hard to create what the Barclays team calls the "argument for misery".

Fortunately there is also an argument for happiness. In a nutshell, it runs like this.

For a start, we have as a society a stock of assets against these rising liabilities. True, many people's financial assets have declined after a poor three years on the stock market. But this fall has been offset by a rise in the value of their homes. Of course, that does not apply in every case, but overall it seems that assets have carried on rising. Total net worth has remained remarkably stable at around five to six times income (third graph), while income itself has been rising.

What happens if house prices fall and/or interest rates go up? It seems that the mortgage lenders have learnt something from their experience of the early 1990s. While a few first-time buyers are getting mortgages of more than 100 per cent, there has been a sharp fall in the proportion of loans for more than 90 per cent of the value of the property. So there is a larger equity cushion for most people.

In addition, the labour market is much stronger now than in the early 1990s, for unemployment is much lower. People may not have a greater security of employment - they may still lose their jobs - but at least they have a much greater chance of finding a new one.

What about the low level of savings? We certainly save too little, but if you allow for inflation, the savings rate is not as low as it looks. When inflation was high, people needed to put aside money just to maintain the real value of their savings. Now that it is much lower and seems unlikely to revive, savings are not low by past standards. In any case, incomes are not as volatile as they used to be, so the need to save for that purpose is not as great.

And the blow from higher interest rates? The bad news is that they will rise higher in the next two years, perhaps to 5 per cent, maybe a little more. But they are most unlikely to rise by anything like the amount they climbed in the early 1990s. Then, UK interest rates were inflated by the need for high rates in Germany, as Britain was a member of the European Exchange Rate Mechanism. Were we now a member of the eurozone, we would actually have lower rates, which would be catastrophic. But we are not. So UK rates can be set to levels that are appropriate for the UK economy and the UK housing market. While a rise to 5 per cent would clip real incomes a little, the highest conceivable rise would not devastate them in the way they were hit in the early 1990s.

So should we be really concerned about household debt? I find the case for cheer stronger than the case for gloom - but with one absolutely crucial reservation.

I don't think there is a general catastrophe looming. It is almost inconceivable that we could allow interest rates to surge to a level where they caused either a housing crash or the widespread misery of the early 1990s. The growth of indebtedness will have to be checked, and that is why higher rates are needed. Some individuals will find this tough but the economy as a whole should continue to grow. House prices may well fall a little but they are unlikely to collapse. On the other hand, they will not rise much for a long time. That leads to my central concern.

The real problem is a longer-term one. It is that people who have borrowed heavily will not be able to rely on inflation to whittle away the real size of their debts. So they will face not a short-term disaster but a long-term grind.