There is a household debt problem

Written by Dr. Vincent Cable MP, Liberal Democrat Shadow Chancellor of the Exchequer and published in Liberal Democrats In Business on Mon 10th May 2004

As the late Lord Whitelaw would have put it: the government and the monetary authorities are vigorously stirring up apathy about the issue of household debt. After warnings last October from the Bank of England about excessive household debt the fears have since been played down and the scaremongers are being put firmly in their place. The argument essentially is that because interest rates are low debt servicing is comfortable.

But the worriers, who now include the chairman of the City watchdog, the Financial Services Authority, point to record levels of household debt in relation to earnings, now 125% as against 40% back in 1980. Four fifths of the debt is secured against appreciating house prices which, in relation to income, are at levels comparable to those just before the house price crashes in 1973/75 and 1990/1992. Net lending to households is rising at levels last seen in the Lawson boom. There is also growing evidence of debt distress in the form of record personal bankruptcies and 20% of those with unsecured debt are borrowing to service the loans.

In fact both sides are right. The difference is not over current facts but over expectations. Consumers are borrowing on the assumption that employment will remain at recent high levels, interest rates will remain low, income growth will remain strong and house prices will remain high. The last three of these assumptions are already looking questionable and a sudden change, leading to a sharp cut in borrowing and spending, could then precipitate a recession.

In fact there are two distinct debt problems. First, there are some borrowers, mainly in low income households with unsecured debt, who are in severe difficulty. Debt as a manifestation of poverty is a very real issue though it is not a macroeconomic issue. It does however call for action on several fronts. There should be easier access to genuine independent, cheap, financial advice of the kind which CAB's offer on a modest scale rather than high cost and often unscrupulous commercial debt 'advice'. There should be access to emergency lending which is not exorbitantly costly, and the Social Fund could be restructured for this purpose. There has to be more effective protection from loan sharks without. None of these are easy or offer dramatic short term benefits; but, at present, little is being done at all.

The other debt problem has potential wider implications. Continuation of comfortable balance sheets of households with big mortgages depends on the absence of a serious crash in house prices plunging substantial numbers into negative equity.

The worry is that, even within overall financial stability, there can still be 'boom and bust' in asset markets, of which, in Britain, housing is the most important. Just as stock markets see 'irrational exuberance' so do property markets. There is evidence that some of the demand for mortgage credit is speculative in character prompted by expectations of capital gains no longer available in equities and by panicky first time buyers who would be better served by renting accommodation but fear being left off a house price escalator.

On the lending side of the market, as Barclay's Matt Barrett has been frank enough to acknowledge, a few aggressive lenders are pushing loan to value ratios and income multiples into the hitherto uncharted territory leaving their more conservative competitors to follow suit or lose market share. These are the key ingredients in a potentially unstable asset bubble.

There is no mechanism at present for dealing with asset bubbles. Interest rates cannot be used proactively since asset inflation (or deflation) is not part of the mandate of the Bank of England MPC and the new inflation index does not even include house prices in its measurement.

Prudence demands some thought as to how a housing bubble and associated debt should be managed. At present the problem is being largely assumed away: But sooner or later the issue will have to be faced: if the prices of mortgage finance (interest rates) cannot be varied to reflect the state of asset markets, what other mechanisms are available? Should not the quantity of credit be a matter of concern to the monetary authorities?

The conventional view is that the authorities no longer have any leverage over the amount of credit available. In liberalized markets, it is argued, old fashioned credit controls no longer work. In competitive, globalised markets, ingenious lenders are likely to be one step ahead of the regulators. Banks are required in any event to observe prudent reserve requirements under international (Basel) rules and by national regulators to avoid solvency risk. Both involve adjusting reserves to reflect the state of asset markets and therefore, the risks of loans.

It does not require too much imagination to see how their remit could include a requirement for reserves of mortgage lenders to be adjusted counter cyclically or the establishment of guidelines for prudent lending in respect of, for example, loan to value ratios. A simple meditate step would be tightening up self-certified mortgages.

Any intervention by the Bank of England or the FSA would have to be guided by an independent and expert view of the asset market by the MPC or a parallel body. It would not be necessary to estimate as precise as the equilibrium price of housing but to make judgments as the likelihood that the market is over or undervalued. The framework sketched out above clearly requires elaboration and debate. At present there is none.

The government is clearly hoping for the best. Indeed it is possible that continued economic stability, a gradual spontaneous adjustment in household balance sheets and a 'soft landing' in the housing market will, together, remove anxiety about household debt. But, it is the job of policy makers to prepare for the worst case scenarios which are all too plausible.