Stephen King: Bank may need to take a different path around debt mountains

The problem lies more with the path for asset prices as opposed to debt itself
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The Independent Online

When you look back at your life, you might sometimes wonder whether things could have turned out a little bit differently. Sometimes you will have made the right choice, both because you had the right intentions and because the outcome was roughly as expected. Sometimes, you will have made the wrong choice, even if you had the best of intentions. On other occasions, you think you have made the right choice, only to discover subsequently that you are waylaid by "Events, dear boy, events", as Harold Macmillan would have put it. You may hope to get back on track but, even if you're lucky enough to do so, the process could still be long and difficult.

Underneath it all, central bankers are also ordinary folk, and they, too, face similar difficulties. Take the Bank of England, for example. It has a very transparent mandate: to hit an inflation target, currently centred on a rate of 2.5 per cent with an allowance of 1 per cent on either side. This, perhaps, can be considered the economic equivalent of the utilitarian's pursuit of happiness: on the surface, a seemingly reasonable objective but one that is, firstly, difficult to define and, secondly, difficult to reach on a sustained basis.

A utilitarian could choose to pursue happiness in the short-term by taking mind-expanding drugs but might regret his decision later on. Similarly, a central bank might try to pursue its inflation target in the short term by persuading people to take on lots more debt, only to discover that its ability to hit the inflation target in later years has been seriously reduced. At the Bank of England, the Monetary Policy Committee's life has been relatively short but, already, there is a sense that past decisions are being questioned. A while back, the Monetary Policy Committee (MPC) argued that a two-speed economy was better than an economy with no speed at all. Now, however, the Bank frets about the debt levels that have built up in response to the pursuit of the "two-speed model".

The ideal mantra from the Bank of England should, of course, be "sustainable growth is ideal" but, in effect, the inflation target doesn't really give the Bank that option. If the global economy is unexpectedly weak, the Bank is obliged to boost domestic demand - through lower interest rates and, thus, higher borrowing - to ensure that the inflation rate does not undershoot the target set by the government of the day.

Of course, the MPC knows all about these dilemmas and many of them show up from time to time in the MPC's published minutes. However, the MPC believes that, by talking about these things openly and, at the same time, by having a clear inflation objective, it will follow an easily intelligible course: by succeeding in this ambition, the markets will hopefully never be on the wrong end of an unpleasant shock. To use the MPC's own aspirational mantra, Mervyn King, the new Governor, once famously proclaimed that "our ambition at the Bank of England is to be boring".

Contrary to popular opinion, though, economics isn't always boring. The problem for any policy-maker lies not so much in knowing what you want to achieve, but rather in knowing how to get there, when to get there and whether unexpected obstacles will appear in your path. The Bank of England's latest Quarterly Bulletin (see highlights some of these dilemmas. The Bulletin reveals - rather clearly - that the Bank and, hence, the MPC are becoming increasingly interested in the issue of debt.

Two papers within the Bulletin ("Balance Sheet Adjustment by UK Companies" - Philip Bunn and Garry Young) and "Trends in Households' Aggregate Secured Debt" (Rob Hamilton)) focus on two specific aspects of the UK domestic debt story. Reading the papers separately is an interesting exercise in itself. Reading them together, however, suggests that the Bank is rather too interesting to satisfy Mervyn King's aspiration: more specifically, the Bank has performed a sin of omission by choosing not to talk about the economic challenge that, in common parlance, might be described as the "bleedin' obvious".

The first paper, on UK companies, comes up with a measure of the "equilibrium" level of capital gearing and then compares this measure with actual capital gearing. The paper defines capital gearing as net debt in relation to the market value of the corporate sector, as reflected in share price movements. To cut a long story short, the paper concludes that the current level of gearing is way too high compared with the "equilibrium" level (left-hand chart) and argues that companies will focus very much on debt reduction in the years ahead. To do this, the authors argue that the emphasis is likely to be on lower dividends - to make room for debt repayment - and greater equity issuance - which raises the denominator of the gearing ratio. Capital spending may also be weaker than might normally be the case as companies grapple with the consequence of their earlier exuberance.

The second paper, on secured household debt (right-hand chart), suggests that, although recent increases in household debt levels may have gone a little too far to be conventionally explained, the longer-term trend will still be one of rising debt levels. As the author points out, "because only a relatively small fraction of the housing stock changes hands each year, the aggregate level of debt responds relatively slowly to changes in house prices. So the recent increases in house prices could lead to continuing increases in the debt to income ratio over the next five to 10 years". The paper suggests that these increases in debt would be entirely appropriate given the current position of the housing market.

Reading these papers, you're tempted to conclude that, if there is a debt problem, it's more likely to be in the corporate sector than in the household sector. Yet, this doesn't seem right to me (and, to be fair to the authors, their detailed discussions - as opposed to the summaries that most people are likely to read - seem to recognise the fragility of their arguments). The problem lies more with the path for asset prices as opposed to debt itself. Corporate capital gearing is high not just because absolute corporate debt levels have risen but also because, since 2000, equity prices have collapsed, thereby reducing the size of the denominator. On the other hand, household debt levels don't seem so bad only because house prices have risen a lot in recent years.

Let me put it another way. Had the capital gearing paper been written four years ago, the conclusion would have been entirely different: then, equity prices were high and hence capital gearing was close to its "equilibrium" level. If, in four years' time, house prices end up a lot lower than they are today, then household debt levels will then seem to be too high. Note, though, that in both cases, the absolute amount of debt need not have changed very much: the willingness to hold the debt, though, will have altered because of the changes to asset values.

It is abundantly clear that the Bank is unsure about the importance of debt in meeting its inflation objective. It encouraged higher debt levels during its "two speed" phase but now seems to be worried about the consequences of that policy. To assess the overall sustainability of debt, though, it needs also to think about asset prices. More specifically, it needs to decide whether asset prices should, in some way, be an intermediate monetary objective in themselves or whether, instead, they should be left purely to market forces. The former could upset the allocation of capital. The latter, though, leaves the Bank vulnerable to asset price shocks - events, dear boy, events - that could throw it off the twin paths of sustainable growth and controllable inflation.

Stephen King is managing director of economics at HSBC