Household Debt: What is to be Done?

Written by Dr. Vincent Cable MP, Liberal Democrat Shadow Chancellor of the Exchequer and published in Liberal Democrats In Business on Thu 1st Apr 2004

It is becoming fashionable to worry about household debt and the housing market against which 80% of debt is secured. Those of us who warned of these dangers over a year ago are now being joined by a growing number of city analysts, while the deputy governor of the Bank of England, Sir Andrew Large, publicly expresses some of his colleagues' anxieties.

Three main indicators taken together cause these anxieties. First, the ratio of debt to post tax income is at the unprecedented level of 135% and is rising rapidly as the growth of debt far outstrips nominal GDP. Second, the apparently comfortable level of interest payments in relation to income obscures the full cost of mortgage debt repayment, as well as interest, such that the rise in interest rates anticipated in financial markets could drive servicing costs to the unsustainable level of the early 1990's. And, third, the apparently comfortable household balance sheet position looks very different if there were to be a collapse in the value of the main household asset, housing, which the IMF, from the vantage point of international as well as temporal comparison, deems to be 30% overvalued.

But while there is a growing consensus on the problem, there is little agreement on the solutions. The key instrument available is interest rates but the mandate of the Bank of England Monetary Policy Committee does not include asset inflation and its inflation target is now based on the new CPI index which excludes housing costs. Aggressive use of interest rates would moreover further unbalance the economy by pushing up the exchange rate and depressing the traded, mainly manufacturing, sector even more. Since interest rate movements have been, as a consequence, very moderate and gradual, they have had no discernible impact as household debt accumulates and house prices rise.

The default position is for the authorities to do nothing, beyond issuing veiled warnings to influence opinion, and let the bubble burst of its own accord, as did the stock exchange a few years ago. Supporters of a laid back approach argue that sharp correction in house prices, and the emergence for some of negative equity, need do no great harm since only small numbers will need to realize the capital value of their assets. Some reckless lenders and some feckless borrowers would pay the price for their folly in bankruptcy and repossession, but their example would encourage others to behave more sensibly in future. Moral hazard would be avoided. And any deflationary shock can be countered by expansionary monetary and fiscal policy.

Although not phrased in quite these terms: that is current government policy. There are, however, risks. Boom and bust and associated costs would return. There would be a large number of individual casualties. The process of recovery might not be easy or straightforward since - as in Japan - households could struggle to rebuild their balance sheets with a prolonged abstinence from consumption.

Even if the Bank of England and the Treasury feel they can do more than raise eyebrows and issue warnings, their authority would be enhanced if they maintained a set of sustainable household and prudent lending indicators, like the Chancellors fiscal rules, or the World Bank's sovereign debt measures, which would provide a guide to markets. It could also be reassuring to know that the Treasury or the Bank of England are seriously monitoring the housing market so that there is some informed assessment of how far the current boom is driven by speculative demand as well as real factors.

There are two further approaches to policy which could, and should, be explored. While it is no longer possible - let alone defensible - to ration credit as in the era before deregulation, it is possible to influence the volume of lending of UK banks by managing their reserve requirements. These requirements are applied in any event to safeguard the system from systematic risk. The requirements could be weighted in terms of each individual bank's exposure to the UK domestic property and personal loans market and their loan to value ratios. Those banks with exceptionally high ratios would face more stringent requirements. The argument advanced against such intervention is that foreign banks would circumvent it. But in practice it is implausible to suggest that policy would become unaffected because participants in the retail market would surf the internet for large mortgages from obscure foreign banks which are not represented in the UK.

Beyond that, a major issue is the lack of ownership of the interlocking issues of household debt and the housing market. The Treasury, the Bank of England, and the Financial Services Authority form a kind of Bermuda triangle inside which responsibility has disappeared. I have tried in vain to extract from the government by parliamentary questions any indication of which is the lead agency. There is a series of regulatory issues not being faced. The restraining burdens of regulation are more severe for savings and investment than for borrowing and debt promotion. Bank employees are systematically bonused for debt promotion through loans and credit cards and go unrewarded for offering prudent advice to customers. The payments insurance market is monopolistic and involves massive overcharging (the OFT is considering the matter). Despite numerous inquiries by the Office of Fair Trading and Parliamentary Select Committees little progress has been made to produce standardized simple statements of charges for users of credit cards. I hesitate to suggest that we appoint a Debt Tsar since we already have one, the Chancellor, who should emerge from his current state of abdication and denial.