Philip Coggan: Getting back to normality

When we look back at the big economic changes of the past 10 years, one of the most startling is the rise in household debt. Throughout the 1990s, debt chugged along at roughly 100 per cent of household income. Then it took off, reaching 160 per cent by 2007, and has barely fallen since then.

Lax lending standards, low interest rates and rising house prices all bear part of the blame for this shift. Indeed, the three go hand in hand; rising house prices inspired lax lending and low interest rates persuaded consumers to take on bigger mortgages to buy houses.

Now we have got here, how do we get back to normality – defined as a ratio of 100 per cent? Fathom Consulting has looked into this issue, using research by the San Francisco Federal Reserve. The US has seen its own debt explosion, but remarkably, given all the publicity about the subprime housing crisis, the American debt ratio never got as high, even if the fall in house prices has been greater.

In the US, the San Francisco Fed thinks the way to reduce the debt mountain will be to increase the savings ratio from its current 4 per cent to 10 per cent by 2018. That would take around three-quarters of a percentage point off consumption growth every year between now and then, a persistent drag on the economy.

Because the UK problem is bigger, the pain will be greater. On the same gradual progress seen in the Fed model, the savings ratio would have to rise to 20 per cent by 2018, knocking 2 per cent off consumption growth every year. That is a recipe for a decade of stagnation. Alternatively, Britain could get there more quickly, by knocking 5 per cent off consumption growth over the next two years – a very deep recession.

That might sound like good news for financial advisers, who could expect a bonanza of demand for savings products either way. But these calculations assume consumers will use some 80 per cent of their net savings to reduce debt; the credit card and mortgage companies will be getting the bulk of that cash. That is a pretty bold assumption. US consumers started to pay down their debts last year. But according to Fathom, since records began in 1963, there has been no quarter when UK consumers have made a net repayment of secured debt.

If instead, consumers use their savings to build up financial assets, it will be even harder for them to get the debt ratio down. The process will either be drawn out or the fall in consumption greater. So what would be good news for financial advisers would be very bad news for the economy as a whole.

From the point of view of the client, repaying debt is probably the best option. Clearly, it is a far better bet to repay credit cards costing 19-20 per cent than to invest in corporate bonds or the stock market. Even with cheap fixed mortgage rates available at 3 per cent, a higher rate taxpayer would need to earn 5 per cent to generate the equivalent income. Nothing guarantees such a rate, and one would want a sizeable risk premium (three or four percentage points) before, in effect, borrowing to bet on the financial markets. After their experience of the last 10 years, few consumers will probably be willing to do so.