Economic Commentary: Facing up to the national interest

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The Independent Online
Since the spring of last year, there have been three high tides of business and consumer confidence. The latest and strongest has recently ebbed, but the UK economic vessel is still moored in the harbour. Why? It has become fashionable to blame the Germans and their refusal to lower interest rates. Or the decision to join the Exchange Rate Mechanism in October 1990, or the Government's unwillingness to give the economy a fiscal boost. Yet, while each of these factors may be unhelpful, none can be described as the central problem.

The private sector - households, charitable trusts and non-financial companies - has two fundamental difficulties: its assets are overvalued and its debt service burden is increasingly unaffordable. These inter-related tensions are most obvious in the commercial and residential property markets, but are not confined to them. At a conservative estimate, second-hand house prices recorded in private sales are still 10-15 per cent above comparable auction market valuations.

As long as this pretence of assets' true worth is maintained, large segments of the housing market will remain jammed. Estate agents may consider that they are performing a valuable service to home owners in sustaining the existing house price structure, yet their actions have contributed to the monstrous inefficiency of the market. The turnover of houses has slumped to its lowest level since 1974 and the stock of unsold houses in the hands of mortgage lenders still stands at over 68,000.

The overvaluation of industrial and commercial property is harder to prove, for the simple reason that so few trades are taking place. How much confidence can be placed in valuations when market turnover is virtually zero? Since property assets also appear in the balance sheets of small and large companies, the overvaluation problem has spread to banks, insurance companies, hotels and many other sectors. How many companies' balance sheets can still be said to be conservatively valued? Considerations of this kind have already impinged upon the valuation of the equity market, and hence the value of pension and insurance funds and other investments.


The unwillingness of individuals and firms to accept realistic asset values is perpetuated as long as there is little or no pressure to raise cash. For the vast majority of households, this description remains valid; but for increasing numbers of businesses, asset sales offer the only hope of survival. Moreover, the liquidation of thousands of businesses each year has significantly increased the supply of second-hand business and office equipment. This undignified scramble for cash can only result in the further erosion of asset values.

To understand why the corporate sector is suffering so much more than the personal sector, it is necessary to examine their respective debt service burdens. The chart shows the respective net interest payments of the two sectors in relation to their non-interest income, after deduction of tax and social security contributions. Despite the drop in interest rates from 15 per cent to 10 per cent, the burden of debt service is only marginally less onerous today than at its peak. On consensus expectations of interest rates for the coming 18 months, progress in reducing the net interest cost will remain slow. The contrast with the recession of 10 years ago is particularly illuminating.

The explanation for these high net interest burdens lies primarily with the accumulation of net debt since 1985. Corporate net debt escalated from pounds 41bn to pounds 109bn in the following six years. The interest accrued on pounds 191bn of borrowing at an average cost of 1.5 per cent over base rates is about pounds 23bn per annum; the interest received on pounds 82bn deposited in the short-term money market is a mere pounds 8bn. An interest gap of pounds 15bn compares to annual non-interest income (after tax) of around pounds 80bn, giving a ratio of about 19 per cent.

Personal net debt rose from almost nothing in 1985 to pounds 61bn at the end of last year. Prior to 1985, the personal sector (in total) was normally a net beneficiary of interest payments; today, more than 3 per cent of the average household budget is eaten up in net interest payments. These calculations do not include the interest relief granted by the Government, but rightly so, for the cost of these reliefs must be financed by the private sector in some other way; either through the taxation of current income or through additional borrowing. To an increasing extent, the latter course is being followed.

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There is another twist to this story. As the profitability of the banks and building societies is compromised by a high level of bad-debt provisions, so pressure accumulates within these institutions to widen the spread between their loan and deposit rates. This raises the net interest cost paid by the private sector for any given amount of net debt. The poorer the quality of a bank's outstanding loans, the wider its interest rate spread is likely to become, and the greater the likelihood of arrears cases. Unpaid mortgage interest is currently mounting at an annual rate of about pounds 1.5bn.

Of course, within the overall picture there are significant variations in experience. But the important point is that an incidence of debt delinquency of even 5 per cent can be enough to contaminate the whole credit and banking system. The lengthy contraction of UK private sector consumer and capital spending owes a great deal to the actions of this insecure minority. But it is compounded by the increasing caution of a much wider spectrum of consumers and companies.

The desire of individuals and firms to reduce indebtedness has seldom been stronger, but its implementation is proving awkward. One way is to pay off the most expensive forms of debt by drawing down bank or building society deposits. This eases the net interest burden but might leave the person or company with a shortage of liquid assets in a crisis. A new borrowing facility may well cost more than the old one. A second way is to reduce spending and repay debt with the proceeds. This is uncomfortable for the party concerned and for the economy, unless it provokes an immediate fall in prices of goods and services. The third method is to repay debt with the proceeds of asset sales, the effects of which have already been discussed. Whatever the method, the result is deflationary.

The UK debt predicament can be characterised as step one on the path to depression, as Irving Fisher defined it in 1933. Without spelling out the next eight steps, it should be obvious that this is a path to be avoided at all costs. When economic policy finally confronts its true enemy, it must decide between fiscal reflation and monetary reflation. To reclaim its sharpest weapon, control over real interest rates, the ill-fated commitment to the ERM must be relinquished.

Peter Warburton is chief UK economist at Robert Fleming Securities. Gavyn Davies returns next week.