Thursday, May 1, 2008

How much is enough

If I could put one question to the banks it would be "how much debt can UK households take on before they think it is a problem?"

Current debt levels are staggering. As of January this year, the ratio of total household debt to post-tax income was 167 percent. Since 2000, this ratio has risen by about 60 percentage points. This is a huge, historically unprecedented increase. We have become a nation of debtors.

Mortgage debt accounts for the greater part of this increase. In January this year, debt secured on housing accounted for about 75 percent of the total.

Until recently, the housing bubble was the great factory of debt. It was a simple production process; banks provided the credit, which increased effective demand for housing. As people used this credit, house prices inflated. People then began to believe that prices could only go one way. They demanded more credit; the Banks provided it; and prices went up further.

Last summer, debt production ground to a halt, at least in the housing sector. Banks went on strike and as soon as debt factory stopped, house prices began to tumble.

However, it is not just housing debt that has been increasing. Unsecured debt - mainly credit cards - is also on the rise. Again, in terms of household post tax income, unsecured debt is up around 10 percentage points since the beginning of the decade.

I look at these debt numbers and three thoughts enter my mind.

The first is a sense of detachment. These numbers have nothing to do with me. I have no debt, and my personal finances simply have no connection to this deeply troubling vista. Moreover, I know some people who, like me, have avoided personal debt. So, these debts are concentrated in some but not all of UK households. This suggests that on a personal level, these debt numbers understate the problem.

However this sense of detachement is limited. I know plenty of people struggling to cope with debt. Within my circle of family and friends, those who went down the rocky road of debt found only misery and unhappiness. Debt ruined their peace of mind. It raised stress levels and just brought unnecessary financial pressure. It also prompted a lot of futile consumption, as if a flat screen TV could make debt worries disappear.

Second, these debt levels look like modern form of serfdom. Debt limits one's options, it compromises one's independence. It forces people into crappy, marginally better paid jobs, just to pay off the banks. When you owe debt; the bank owns you.

Finally, the overall magnitude of personal debt is now so great that it has distorted economic policy. Rather than pursuing the objective of low inflation, which would require significantly higher interest rates than we have now, the bank of England have cut rates. Low rates are necessary because commercial banks could not absorb even a modest increase in household default rates.

This brings me back to my original question; how much more debt could UK household possibly accept? Would the banks be happy if the ratio of household debt to income crept up to 180 percent? Would they feel comfortable if it tipped 200 percent? Could the banks live with a 220 percent ratio?

Perhaps the question should be how much debt are we willing to accept from the banks? Over the last decade, households have taken on too much. Perhaps the credit crunch is a blessing in disguise. It may begin a process where household debt levels begin to fall to lower and more sustainable levels.


  1. Alice,

    Interesting. Quite alot of your posts are leading you right up to the door of deflation but you don't walk through it.

    Banks have pulled out of the debt factory. Consumers are maxed out.

    You just said prices got bid up and credit expanded. Don't you believe prices fall as credit evaporates? That as people borrow less and pay down existing debt, this reduce money velocity and also new credit creation.

    For a long time people with money have had to compete for products against people with credit. When it's a TV or pair of jeans, the answer was "produce / import more" and thus the rampant overcapacity in China.

    When the product was a socially stratified good (check out Fred Hirsch's "Social Limits To Growth" for a good discussion) then it's not possible to produce out of the squeeze and therefore prices bubble up and the responsible are outbid by the reckless.

    Now what's left? Overcapacity = short term price drops until the capacity reduces. Stratified goods = collapsing prices for the years until credit reflation.

    For now, bubbles in commodities and gold are masking this deflation.


  2. Nick - Nice comment... though I disagree that gold is relevant in this context. I also expect to see medium term deflation.

    Alice... I've an absolutely wild thought I'd like to raise (if not justify). Your graphs don't so much show debt as credit - I suspect... the numbers are supplied by lender rather than borrower records. I wonder if there is a discrepancy?

    I'm aware of several stories of mortgage fraud - where fictitious individuals in London bought entire blocks of flats at £300K plus per unit... and I never fail to be shocked by credit card fraud... I believe I've met a man who supported himself by selling goods he'd bought retail at 30% discount for cash - he'd been at it for many years. I also know many people who have had fraudulent transactions arrive on their credit cards - yet the police no-longer accept public report of credit card fraud - even if there's an option to catch the criminal red-handed... for example... on collecting first class train tickets. A credit card industry spokeswoman was quizzed on TV last year - and it transpired that for the millions of frauds that must have happened during the year, only one - on average - had been reported to police in each county. To me it smells fishy. I wonder if a proportion of debt is actually bad debt arising from fraud - either committed as above - or by financial services insiders?

    If there is a significant discrepancy, I'm entirely unclear about what the implications are.

  3. Asteve,

    The debt numbers are from reports of commercial banks and other financial institutions. So, you are right. The debt numbers are credit numbers, reconfigured according to the final user.

    Fraud is a big issue. However, I would distinguish between two kinds of credit-related fraud. Credit card fraud and mortgage fraud.

    Credit card fraud more or less shows up immediately in default rates. These rates are high (I have the data and I will, perhaps, post them). This fraud is basically an ongoing thing and gets netted out of the data on an ongoing basis.

    Mortgage fraud typically involves people taking out loans and misleading banks about the true level of their creditworthiness. A good example is the Casey Serin case in the US. This kind of fraud only shows up when prices fall and the default rate shoots up. Up to now, default rates on mortgages are at very low levels, but as the house prices crash, much of this fraud might suddenly show up and surprise the banks.


  4. Nick

    No, I don't go with the idea of a generalized deflation. However, I do see house prices falling(unsurprisingly given the blog).

    I have several reasons for not believing in the deflation story. Briefly, the are: i) the data doesn't support, monetary growth is still strong, prices are rising, and in some cases quite quickly, ii) world liquidity conditions, there is still a huge amount of money in many parts of the world (esp. emerging markets). This will keep world commdity prices high, leading to higher manufactured good prices (see chinese inflation for further evidence), iii) sterling has to fall, leading to higher inflation, and finally iv) inflationary expectations are rising. Once they do it is possible for both unemployment to rise, output to fall and inflation to remain quite high. Without going into too many details, this is equivalent to seeing the long run NAIRU rising (the non-accelerating inflation rate of unemployment).

    So, in summary, I don't believe in the deflation story.

    However, I am always ready to admit (grudgingly usually) that i am wrong.


  5. Alice... I wasn't suggesting that you were misleading by using credit numbers rather than debt numbers... it was just the clearest way I could think of to express my musing.

    I don't see why credit card debt must necessarily have quicker default than mortgage debt. If a criminal has an effectively unlimited supply of credit (through a broker; stolen credit cards; insider who covers up - etc) then the default rate can, in principle, be delayed indefinitely. This was what Enron did... I don't see why it couldn't happen in a different context... but (I hasten to add) I've absolutely no evidence to suggest that this has actually happened... it is just a thought experiment.

    I think your arguments against deflation are weak, however.

    i) I don't think M4 supports monetary expansion - *if* recent high M4 growth figures represent SIVs being dissolved and debt returning to balance sheets. This hypothesis for today's M4 expansion figures would need to be disproved to convince me of monetary growth in a relevant way.

    ii) I think those who've got cash don't want to lend it... and that's why they've got it. People who are rejecting today's prices because they're too risky are unlikely to bid prices higher.

    iii) Devaluing sterling would count if it were not offset by the fact that our only significant export is financial services - an industry in terminal decline following crisis. The only observable effect will be higher import costs and a lower mean quality of life for those earning in Sterling.

    iv) Inflationary expectations are rising. I just think that the expectation will prove to be unsupported in reality and/or people confuse higher import costs with inflation - the former drives up their expenditure but not their income - hence is distinct from general inflation.

    The inflation debate rages... it is almost religious. I'm absolutely convinced that we will continue to see biflation in the immediate future and medium term... i.e. increasing cost of imported goods and declining earnings... and plummeting asset prices. This will necessarily be deflationary - especially with respect to illiquid assets. In the long term - say from 5-10 years in the future, I can imagine inflation starting to take over from biflation... in order to do that we need to establish a strong exporting industry. To do that in 5-10 years is extremely ambitious - to expect things to change quicker is blinkered - IMHO.

  6. This has been my curiosity as well. Just how much debt will be absorbed before the whole house of cards comes crashing down?

    The lower rates since the BOE became independant means that people can borrow more than they used to before because interest rates are lower.

    I remember getting a car loan for £1500 in 1995 and the APR was something like 13%. I repayed it in 12 months to minimise the interest hit.

    Before the credit crunch you could get an unsecured loan for around 7%.

    I think you have to bear this in mind when looking at the growth of debt. Nevertheless, banks have been too generous, and now that they're not handing out cash for virtually nothing anymore, the debt bubble will implode, along with the economy.

    ps. Have you ever considered the effect the baby boomers are having on the economy? All with plenty of money. I think my aunties and uncles alone keep the economy going with the amount they spend between them!!!!!!!

  7. Suggest you read Karl Denninger's latest. Looks like we're in the same mess as the US.

  8. That post is almost poetry. Did it just come out like that in one breath or did you have to slave for ages to get it that sleek?

    Anyway, how come it's only nutters like us who realise that credit bubble = asset price bubble, they are two sides of the same coin.

    You read loads of articles in e.g. the FT about banks and reckless lending and how to fix it. You also read loads of articles bemoaning/celebrating house prices rises/falls (according to taste). You've got to look at both in tandem.

    My policies, FWIW, are to introduce Property Bubble Tax (to prevent asset bubbles) and also to scrap the BoE and tell banks to fend for themselves (to discourage reckless lending), no bail outs, nothing.

  9. My policies:

    1) Scrap the BoE and deposit insurance. Let people take control of their own counterparty risk and remove the moral hazard. Let the market figure out interest rates.

    2)Go to the gold standard tomorrow, by giving an open promise to exchange pounds for gold at the spot rate at the moment the standard is announced.

    3) Phase out fractional reserve lending over the next couple of years by a gradual but relentless increase in reserve requirements as a proportion of assets. Once a critical point is reached, outlaw loans that are not covered by actual deposits.

    Implement those and all credit / inflation related troubles evaporate, sterling is protected and long term stability is increased.


  10. Nick... :-O

    I disagree about deposit insurance, but I can see your point. I think that society needs to be confident in electronic money, and that governments need to support this for the good of civilisation.

    I utterly disagree about the "gold standard" - this is handing control to a bunch of mercenaries... which I feel is utterly unjustifiable. The public should own the money supply not some dude who stole a lot of metal and remembers where he dug a hole.

    I am *ABSOLUTELY* in favour of phasing out fractional reserve banking. Civilisation does not need the dangers it introduces... it is an arcane hang-over from the days of the gold standard where safe credit demand grew faster than gold could be mined.

    To suggest that our monetary system should be tied to a single asset in future is one of the most dangerous and corrupt possibilities imaginable. I hope no-one ever takes it seriously... it is the path to the greatest human misery imaginable.

  11. Only comment I would make is that inflation is very low compared to other UK periods of house price bubbles, this means that debt is real debt and will have to be paid off, rather than being reduced by 10%+ year on year inflation.

  12. Nick - this does not compute:

    3) Phase out fractional reserve lending over the next couple of years by a gradual but relentless increase in reserve requirements as a proportion of assets. Once a critical point is reached, outlaw loans that are not covered by actual deposits.

    That's exactly what FRB is - allowing banks to finance a large part of their loans with actual deposits. I agree that the ratio should be changed - banks are getting away with Tier 1 ratios of only 7% or something, in other words, 93% of loans are financed by deposits, but apart from the bank's own capital (a meaningless figure, as it is arrived at by subtracting deposits and other borrowings from total assets) what else can you use to finance loans apart from deposits (and other borrowings, which are just another form of deposit)?

    My crash course in FRB is here.

    And like I say, the 'financed by' side is only half the equation. The other side is the fact that banks were making reckless loans on over-inflated asset valuations, which is why we need 'Property bubble tax' to keep house prices low and stable.