Paying for the excesses of our past: Britain's high level of debt is the greatest obstacle to recovery, Peter Torday reports

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The Independent Online
THE LATEST sets of UK statistics are a welcome sign that the recovery is strengthening. Housing starts have shot up, demand for consumer credit stands at a three-year peak, business failures have slumped and exports are growing faster than imports.

But how great are the risks that the recovery could run out of steam? Recent surveys by Gallup and PA Cambridge Economic Consultants suggest that consumers are still worried about the impact of the November Budget. Consumer spending may have been more than resilient this Christmas, but the surveys suggest it could easily taper off when the Budget tax increases take effect next April.

Yet a more fundamental risk to spending and recovery emerges in the latest Economic Outlook from the Organisation for Economic Co-operation and Development. It warns that the world recovery is still feeble enough to be knocked off course by heavy levels of household and corporate debt persisting in many rich industrial countries.

Britain is one of the worst cases. Alongside other English-speaking countries, the Nordic states and Japan, the UK private sector rang up record debt during the high-flying 1980s.

The recession that followed sent asset prices, the main security for the spiralling increase in debt, into a tailspin. Recovery from this sort of economic shock has proved a more painful and protracted process than in previous business cycles, especially in a world in which prices seem likely to be extremely subdued over the next year or so.

As a result, the OECD believes that these economies - including Britain - will remain unusually sensitive to interest rate changes.

'In all these countries interest rate reductions have played an important part in the adjustment, accounting for much of the improvement in private sector cash flows and helping to relieve the stress on financial institutions,' the OECD says. The organisation suggests rates may have to be lower, in real terms, than was normal in earlier business cycles.

For people and businesses, high levels of debt become more onerous to bear during periods of low inflation because the real level of debt is not eroded by price rises. The drop in interest rates has boosted income, but much of this is set aside to reduce the debt. A high level of savings is thus encouraged and acts as a permanent constraint on higher spending. Despite these efforts to reduce the burden of debt, the OECD says levels are coming down only slowly.

The potential obstacles to the UK recovery still appear significant, according to several indicators. Commercial property prices in Britain have fallen a real 57 per cent since the 1990 peak - the steepest decline of any OECD country that indulged in excessive construction of commercial property during the boom years.

'Adjustment lags in this sector are long, and it may take some time for office vacancy rates to fall back to levels which would support sustained increases in activity,' the OECD says.

Fortunately, residential property prices appear to have stabilised, as they have done in other countries - such as the US and Australia - afflicted during the 1980s with rapid house price inflation.

More worryingly, the UK household sector acquired a greater level of debt than any other OECD country, peaking at more than 80 per cent of national income in 1991, against about 65 per cent in the US and almost 70 per cent in Sweden. (In terms of debt payments to income, Britain is actually better off than the US and Sweden but worse than other heavily indebted industrial countries.)

The only way to resolve problems such as these, the OECD says, is to reduce consumption, asset sales and lower personal investment. The consumer, in other words, will spend less for a long time to come.

An equally dire picture emerges when looking at corporate debt. UK corporate debt to national income only peaked last year. At 173.1 per cent, the UK was exceeded only by Australia. UK firms are therefore being forced to sell assets and cut back investment. If the US experience is any guide, corporate restructuring - usually meaning a reduction in the company's size - will become more widespread.

'Corporate financial restructuring in the UK and Australia has followed a broadly similar pattern to the US,' the OECD says, 'but the adjustments have been slower and probably have much further to go.'

Like other industrial countries, Britain also suffered from financial stress in the banking sector, creating another constraint on recovery.

As banks have increasingly owned up to large loan losses for which they made no provision, they have widened interest margins and tightened credit conditions - forcing businesses to rely on organically generated funds for expansion and new equity issues for those relatively few companies able to tap the markets.

The performance of the US economy may offer an instructive lesson for those attempting to predict how the UK recovery develops.

The US emerged from recession earliest. And yet more than two years since the turning point, the economy only now seems to be building on recovery.

During that period, it only once managed a quarterly growth rate as rapid as the 5 to 6 per cent annual growth rate characteristic of earlier US recoveries.

This suggests - approaching tax increases and spending cuts aside - that it may take some time for our own recovery to become firmly established. The trough of the British recession occurred in April 1992.

But recovery only became discernible to consumers and businesses in 1993. Even today, the statistics suggest, the expansion will be corrugated for some time before being transformed into a sustainable recovery.

A further glance at the US experience is instructive. American real interest rates have hovered around zero for the past two years and only now is speculation emerging that nominal rates will be lifted slightly - a switch from a stimulative to a neutral monetary policy - during the course of next year.

By contrast, UK real rates stand at about 4 per cent and may rise slightly if progress against inflation is maintained. Given that the US economy is saddled with similar debt problems to our own, the case for a further reduction in base rates looks a strong one.

(Photograph and graphs omitted)