Government and Institutions

The problem with high household debt, and what to do about it


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Economic Theory

Government debt in the UK often makes headlines, but the high level of household debt in the UK is arguably no less of a threat to the stability of the UK economy. Research by the NBER found that collapses of debt-fuelled housing bubbles tend to produce especially long and severe downturns. The rapid growth of household debt pre-crisis, driven by rising house prices, was a large contributor to the length of the subsequent recession.


Although British households have been slowly deleveraging since the financial crisis, UK households’ debt is still extremely high by historic and international standards. The household debt-to-income ratio (defined as total liabilities as a percentage of disposable income) of the UK is 145%, compared to 110% in the US and only 85% in Germany. Furthermore, the gradual deleveraging seen in the past few years is unlikely to continue. A confluence of factors, including a long period of low interest rates and expectations of continued low rates; a tightening of the labour market accompanied by strong real wage growth; booming house prices and rising confidence, have led the Office of Budget Responsibility to predict a sharp increase in the level of UK household debt. It will surpass its pre-crisis peak in 2020 to reach an alarming 172% of disposable income. This has been accompanied by a steep fall in the savings ratio from 11% in 2010 to 6.6% in 2015 (predicted to be 4.8% by 2019), meaning that households are extremely vulnerable if a downturn occurs.



-OBR/ONS


The level of household indebtedness is placing, and will continue to place, severe constraints on monetary and government policy, given the lack of any debt-eroding inflation. Households have grown used to anomalously low interest rates, meaning that the Bank of England would find it difficult to raise interest rates due to fears of widespread arrears and defaults. UK mortgagors are generally more exposed to an increase in the Bank rate, as the majority of them are on variable-rate mortgages, unlike in the US where most mortgages are 15- or 30-year term fixed rates. British households also tend to spend a higher proportion of their income on debt servicing: 18% compared to only 10% among US households. PwC found that a further 2% rise in the cost of debt servicing (akin to a modest step towards a normalisation in rates) would cost households on average £1000 per year.


The UK household sector’s relative vulnerability to a rise in interest rates is forcing the Bank of England to keep interest rates low. Small increases from the current rate may not be particularly detrimental to households, but long-term interest rates are a concern. Mark Carney recently stated that he didn’t expect the Bank rate to rise to 2.25% (which would still be well below historic levels) in part because household debt will likely be unsustainable above that rate. However, permanently low interest rates distort the economy in a number of ways, for example by channelling funds from low-return savings accounts into high-risk financial products, potentially increasing financial instability.


The high level of household indebtedness also places a strain on government policy. There is a clear political incentive for the government to keep house prices rising; homeowners are far more likely than renters or first-time buyers to vote, and they prefer house prices to rise. Continuously rising house prices prevent highly indebted households from falling into negative equity and allow other households to increase their consumption by securing even more debt against their houses.


Although the government is undoubtedly aware of the supply problem in the housing market, it favours demand-boosting schemes such as Help to Buy. The Bank of England’s Funding for Lending scheme, which gives banks access to cheap funds, is another channel of easy credit. Due to the inelasticity of supply in the housing market, these schemes can only raise prices further. It would not be particularly difficult for the government to expand housing supply by liberalising planning laws; however, it avoids doing this partly because it is under implicit political pressure from debtors to keep house prices rising. Without reform, the Centre for Economic and Business Research (CEBR) predicts for house prices to rise at around 3.5% over the next five years, significantly above expected wage growth. This will inevitably lead to an increase in debt, as homeowners will be able to take out more secured debt against their houses and first time buyers take out larger mortgages.



-ONS/CEBR


In ordinary times, the government would seek to create inflation to reduce the real value of household debt. The current lack of inflationary pressures, combined with fiscal tightening and few possibilities for further loosening in monetary policy, means that this option is not viable. To ensure financial stability in the long-run, the government will have to take difficult and unpopular steps to reduce the debt burden. The current trough in household debt gives the government and the Bank of England an opportunity to take actions to reduce it before it before it reaches threatening levels. Help to Buy and Funding for Lending should be ended to slow down the rise in asset prices, in addition to a liberalisation in planning laws to allow for growth in house building. Normalising house prices through expanding supply and lowering demand will, along with other benefits of improved labour mobility, lower poverty and lower inequality, help to reduce household debt. The Bank of England must also stop delaying a rise in interest rates before a ‘perfect storm’ of rising wages and low interest rates leads to an unsustainable and difficult to reverse level of household debt.



1 thought on “The problem with high household debt, and what to do about it”

  1. Posted 20/01/2016 at 18:41 | Permalink

    Your suggestions for policy changes make sense with the exception of raising interest rates. The policy of austerity combined with QE for the financial sector (not the real economy) is producing a worldwide downturn within which an increase in rates would simply cause an even deeper slowdown than the one coming. Assets prices are now collapsing having been blown up by QE free money for the holders of capital. The I E A support for free markets presumably does not extend to the largely rigged ones we have experienced in recent years. It is time to concentrate policy on economies and not on the financial sector which long since lost its aiso d’être: it is now destructive of productive activity concentrating on selling pieces of paper to itself, often many times over. Hold on because here we go again and it won’t be the fault of the Chinese. It will be the result of policy choices made which destroyed demand whilst making a few people even richer. It is a very serious failure for neoliberal neoclassical economics.

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