Stephen King: Credit junkies must be weaned off habit or we face crash landing

An economy that is over-dependent on debt can be very vulnerable to a rise in interest rates
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The Independent Online

So, on to phase two. The Bank of England's economic experiment always was a two-stage approach. Phase one: accept that the global economy was weak, boost consumer demand through interest rate cuts and hope for an eventual global revival. Phase two: when the global revival finally came along, slow consumer demand through interest rate increases and hope to avoid a domestic economic collapse. Why go through these two phases? The answer is simple: if the objective is the control of inflation, the central bank has to get overall growth just right and has to put to one side the degree of "imbalance" that might crop up in pursuit of this goal.

The Bank of England has often fretted about imbalances and is well aware of the risks associated with them. So the atmosphere must now be rather tense at Threadneedle Street. We now know that, at its last meeting, the Monetary Policy Committee voted only 5-4 in favour of keeping interest rates unchanged. The hawks appear to be in the ascendant and, by the time we get to the November meeting, there's now a good chance that base rates will have to go up. What does this mean for the British economy?

The answer is not as straightforward as it seems. We can look back at past episodes of monetary tightening and say that an initial increase in interest rates is unlikely to do a great deal. We could go even further and argue that the degree of monetary tightening now priced into financial markets - pointing to base rates of 5 per cent in a year's time, up from 3.5 per cent currently - is also not likely to do a great deal. After all, these amounts are nothing compared with the experience that some of us went through at the beginning of the 1990s. So long as we don't go back to a world of 15 per cent base rates and - ouch - 15 per cent mortgages, we can all afford to relax.

There are, however, two key problems with this view: addiction and the Netherlands. Phase 1 of the Bank's inflation targeting policy was a policy that actively encouraged consumers to borrow more than they would normally choose to borrow: it wouldn't have worked without this encouragement. Consumers now have to be weaned off this rather unusual diet. Perhaps easier said than done. Think of how this story has worked. People borrowed more and, hence, spent more. Demand in the economy rose, pushing up incomes and house prices. Rising house prices made people feel richer and they borrowed even more.

It is difficult to gauge the overall size of this credit bubble. It's even more difficult to gauge the sensitivity of this bubble to any tightening of monetary policy. Take away the support from low interest rates and what happens? Hopefully, there might just be a gentle slowdown in domestic consumer demand and a nice soft landing. On the other hand, we might see the convulsions of a drug addict: starved of his usual "fix", he enters into a world of cold turkey - and we're talking about something far worse than post-Christmas indigestion. Somehow, the Bank has to persuade consumers that they should spend a little bit less, not a whole lot less.

The problem can be simply stated. John Butler, my colleague at HSBC, has worked out that the impact of interest rate changes on consumer behaviour has increased considerably precisely because of the Bank's policy of increasing household indebtedness in recent years. An increase in base rates to 5-6 per cent today would be the equivalent of an increase in base rate to 10-12 per cent at the beginning of the 1990s. In other words, the higher the initial debt level, the less interest rates have to rise to slow consumer spending down.

In one sense, this is rather good news. It suggests that the Bank really will not have to raise interest rates very far at all - and certainly suggests that the Bank should exercise extreme caution in exercising its right to pull the trigger on the interest rate gun.

This brings me on to the Netherlands. As Gwyn Hacche, another colleague at HSBC, has argued, the Netherlands was a miracle economy throughout the 1990s. Strong growth, low and falling unemployment, an apparently very strong fiscal position, a bubble in the housing market and a consumer boom fuelled by mortgage equity withdrawal. Sounds familiar? Well, it should do, because many of the properties of the 1990s Dutch economy have also been properties of the UK economy in recent years.

Over the past two years, though, the Dutch have had a pretty rotten time of it: the economy went into recession, unemployment rose, wages were squeezed and the fiscal position - once so healthy - has started to look increasingly precarious, with the budget deficit heading quickly towards the 3 per cent of GDP upper limit contained within the Stability and Growth Pact. What went wrong? How could such a well-performing economy hit the skids? Well, part of the answer seems to be that interest rates went up - not by much, only 2 per cent or so - but enough to ensure that the economy couldn't continue down the apparently righteous path it had been following through the 1990s.

As the economy slowed, suddenly its underlying frailties were exposed. Admittedly, house prices never collapsed. But house price inflation of 20 per cent fell back quickly: within the space of three years, house prices had stopped rising altogether. In response, consumer spending slowed rapidly: less in the way of mortgage equity withdrawal - an inevitable result of lower house price inflation - meant slower consumer demand, leading to lower income growth and a growing downward multiplier effect. As this deterioration gathered pace, the Government's own finances progressively worsened, leaving the Dutch without any obvious fiscal route towards salvation.

Is Britain in danger of heading in the same direction? Interestingly, the Bank of England has sometimes argued that, so long as actual house price declines are avoided, a soft landing for the economy should be easily achievable. The Dutch experience suggests otherwise. Enough damage can be done from a significant slowdown in house prices, without resort to an early-1990s-style house price collapse. The lesson seems to be this: an economy that becomes over-dependent on a debt-led expansion can be very vulnerable to any action that changes the dynamics of debt accumulation - and higher interest rates act very much to change those debt dynamics.

Fortunately, the UK has a couple of advantages relative to the Netherlands. First, if phase two goes wrong, the Bank of England can change its mind and decide to cut interest rates again: the Dutch, part of the euro, simply don't have that option. Second, the UK has the option of exchange rate depreciation: should the consumer give up the ghost, the exchange rate could fall, giving more support for Britain's exporters. Phase two need not be a disaster for the UK but the Dutch experience does suggest that the Bank of England has yet to successfully conclude its ongoing economic experiment.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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