We have reported frequently in our blogs about concerns over rising debt levels among UK households. We previously noted the concerns expressed in July 2014 by the Prudential Regulation Authority (PRA) that the growth in consumer credit (unsecured lending) was stretching the financial well-being of individuals with implications for the resilience of lenders’ credit portfolios. Now the Chief Executive of the Financial Conduct Authority (FCA), Andrew Bailey, in an interview to the BBC has identified the growing problem of debt among young people.
In his interview Mr Bailey stresses that the growth in debt amongst younger people is not ‘reckless borrowing’ and so not borne out of a lack of willpower or ‘present bias’ (see John’s blog Nudging mainstream economists). Rather, it is borrowing simply to meet basic living costs.
In his interview Mr Bailey goes on to identify generational shifts in patterns of wealth and debt. He notes:
There are particular concentrations [of debt] in society, and those concentrations are particularly exposed to some of the forms and practices of high cost debt which we are currently looking at very closely because there are things in there that we don’t like.
There has been a clear shift in the generational pattern of wealth and income, and that translates into a greater indebtedness at a younger age. That reflects lower levels of real income, lower levels of asset ownership. There are quite different generational experiences.
Mr Bailey goes on to echo concerns expressed back in July by the Prudential Regulation Authority in relation to the growth in consumer credit. The chart illustrates the scale of the accumulation of consumer credit (unsecured lending) across all individuals in the UK. In August 2017 the stock of unsecured debt rose to £203 billion, the highest level since December 2008 when the financial crisis was unfolding. (Click here to download a PowerPoint of the chart).
In concluding his BBC interview, Mr Bailey notes that credit should be available to younger people. Credit helps individuals to ‘smooth income’ and that this is something which is increasingly important with more people having erratic incomes as the gig-economy continues to grow. However, he notes that credit provision needs to be “sustainable”.
BBC Interview
Financial regulator warns of growing debt among young people BBC News (16/10/17)
Articles
Young people are borrowing to cover basic living costs, warns City watchdog Guardian, Julia Kollewe (16/10/17)
Britain’s debt timebomb: FCA urges action over £200bn crisis Guardian, Phillip Inman and Jill Treanor (18/9/17)
FCA warning that young are borrowing to eat shames Britain Independent, James Moore (16/7/17)
Young people are ‘borrowing to cover basic living costs’ and increasing numbers are going bankrupt, warns financial watchdog Daily Mail, Kate Ferguson (6/10/17)
More and more young people are falling into debt – but it’s not their fault Metro, Alex Simpson (20/10/17)
Data
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database Bank of England
Questions
- What does it mean if people are financially distressed?
- What do you think Mr Bailey means by ‘sustainable credit’?
- In what ways might levels of debt impact on the macroeconomy?
- How does credit help to smooth spending patterns? Why might this be more important with the growth in the gig-economy?
- What is meant by inter-generational fairness?
- Of what relevance are changing patterns in wealth and debt to inter-generational fairness? What factors might be driving these patterns?
- What sort of credit is unsecured credit? How does it differ from secured credit?
- Are there measures that policymakers can take to reduce the likelihood that flows of credit become too excessive?
An economy that becomes dependent on credit can, in turn, become acutely volatile. Too much credit and there exists the potential for financial distress which can result in an economic slowdown as people cut back on spending. Too little credit and the growth in aggregate demand is subdued. Some argue that this is what now faces a financialised economy like the UK. Even it this overstates the significance of credit, there is no doubt that UK credit data is keenly followed by economists and policymakers.
Recent rates of credit accumulation by individuals have raised concern. In July 2014 the Prudential Regulation Authority (PRA) of the Bank of England issued a statement voicing its concern that the growth in consumer credit, also known as unsecured lending, was stretching the financial well-being of individuals and that the resilience of lenders’ consumer credit portfolios was therefore reducing.
Chart 1 illustrates the scale of the flows of both consumer credit (unsecured lending) and mortgages (secured credit) from banks and building societies to individuals. It shows the amount of credit net of repayments lent over the last 12 months. In the 12 months to July 2017 the net accumulation of consumer credit was £18.2 billion while that of secured borrowing was £40.8 billion. Although the 12-month level of consumer credit accumulation was down from its recent peak of £19.2 billion in November 2016, total net lending (including secured lending) to individuals of £59.0 billion was its highest since September 2008. (Click here to download a PowerPoint of the chart).
To help put in context the size of flows of net lending Chart 2 shows the annual flows of consumer credit and secured debt as percentages of GDP. In this case each observation measures net lending over the past four quarters as a percentage of annual GDP. The latest observation is for 2017 Q2 and shows that the annual net flow of consumer credit was equivalent to 0.94 per cent of GDP while that for secured borrowing was 1.78 per cent of GDP. While the flows of consumer credit and secured borrowing as shares of national income have eased a little from their values in the second half of last year, they have not eased significantly. (Click here to download a PowerPoint of the chart).
Despite the recent strength of borrowing, levels are nothing like those seen in the mid 2000s. Nonetheless, we need to see the current accumulation of debt in the context of two important factors: debt already accumulated and the future macroeconomic environment. Chart 3 gives some insight to the first of these two by looking at stocks of debt outstanding as shares of GDP. The total debt-to-GDP ratio peaked 90 percent in 2009 before relatively slower growth in credit accumulation saw the ratio fall back. The ratio has now been at or around the 78 per cent level consistently for the past two or so years. (Click here to download a PowerPoint of the chart).
The ratio of the stock of consumer debt to GDP peaked in 2008 at 13.3 per cent. It too fell back reaching 9.05 per cent in the middle of 2014. Since that time the ratio has been rising and by the end of the second quarter of this year was 10.1 per cent. The PRA appears not only to be concerned by this but also the likely unwinding of what it describes as the ‘current benign macroeconomic environment and historically low arrears rates’.
Going forward, we might expect to see ever closer scrutiny not only of the aggregate indicators referred to here but of an array of credit indicators. The PRA statement, for example, refers to the number of , ‘0% interest credit card offers’, falling interest rates on unsecured personal loans and the growth of motor finance loans. The hope is that we can avoid the costs of financial distress that so starkly affected the economy in the late 2000s and that continue to cast a shadow over today’s economic prospects.
PRA Statement
PRA Statement on Consumer Credit PRA, Bank of England (4/7/14)
Articles
Bank of England demands consumer credit vigilance; construction growth slows – as it happened Guardian (4/7/14)
Bank of England warns more defences may be needed against consumer credit Telegraph (24/7/17)
Beware the bubble: Bank of England clamps down on credit Telegraph, Tim Wallace (1/7/17)
Bank of England raises capital requirements on UK lenders amid concerns about excessive consumer borrowing Independent, Ben Chu (27/6/17)
Bank of England tightens mortgage borrowing rules amid fears of debt boom Express, Lana Clements (27/6/17)
Rise in personal loans dangerous, Bank of England official says BBC News (25/7/17)
Bank of England takes action over bad loans BBC News (27/6/17)
Data
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database Bank of England
Questions
- What does it mean if people are financially distressed? What responses might people take in response to this distress?
- How can financial distress affect the economy’s growth path?
- How would you measure the financial well-being of an individual? What about the financial well-being of firms?
- What role mights banks play in affecting levels of financial distress in the economy?
- What does it mean if credit conditions are pro-cyclical?
- Why might banks’ lending be pro-cyclical?
- Are there measures that policymakers can take to reduce the likelihood that flows of credit become too excessive?
- Why do some economists refer to the economic downturn of the late 2000s as a balance sheet recession? How likely is another balance sheet recession in the short term? What about in the longer term?
Ten years ago (on 9 August 2007), the French bank BNP Paribas sparked international concern when it admitted that it didn’t know what many of its investments in the US sub-prime property market were worth and froze three of its hedge funds. This kicked off the financial crisis and the beginning of the credit crunch.
In September 2007 there was a run on the Northern Rock bank in the UK, forcing the Bank of England to provide emergency funding. Northern Rock was eventually nationalised in February 2008. In July 2008, the US financial authorities had to provide emergency assistance to America’s two largest mortgage lenders, Fannie Mae and Freddie Mac.
Then in September 2008, the financial crisis really took hold. The US bank, Lehman Brothers, filed for bankruptcy, sending shock waves around the global economy. In the UK, Lloyds TSB announced that it was taking over the UK’s largest mortgage lender, Halifax Bank Of Scotland (HBOS), after a run on HBOS shares.
Later in the month, Fortis, the huge Belgian banking, finance and insurance company, was partly nationalised to prevent its bankruptcy. Also the UK government was forced to take control of mortgage-lender, Bradford & Bingley’s, mortgages and loans, with the rest of the business sold to Santander.
Early in October 2008, trading was suspended in the main Icelandic banks. Later in the month, the UK government announced a £37 billion rescue package for Royal Bank of Scotland (RBS), Lloyds TSB and HBOS. Then in November it partially nationalised RBS by taking a 58% share in the bank. Meanwhile various other rescue packages and emergency loans to the banking sector were taking place in other parts of the world. See here for a timeline of the financial crisis.
So, ten years on from the start of the crisis, have the lessons of the crisis been learnt. Could a similar crisis occur again?
The following articles look at this question and the answers are mixed.
On the positive side, banks are much more highly capitalised than they were ten years ago. Moves by the Basel Committee on Banking Supervision in its Basel III regulatory framework have ensured that banks are much more highly capitalised and operate with higher levels of liquidity. What is more, banks are generally more cautious about investing in highly complex and risky collateralised assets.
On the negative side, increased flexibility in labour markets, although helping to keep unemployment down, has allowed a huge squeeze on real wages as austerity measures have dampened the economy. What is more, household debt is rising to possibly unsustainable levels. Over the past year, unsecured debt (e.g. personal loans and credit card debt) have risen by 10% and yet (nominal) household incomes have risen by only 1.5%. While record low interest rates make such loans relatively affordable, when interest rates do eventually start to rise, this could put a huge strain on household finances. But if households start to rein in their borrowing, this would put downward pressure on aggregate demand and jeopardise economic growth.
Articles
- The crisis: 10 years in three chart
BBC News, Simon Jack (9/8/17)
Darling: ‘Alarm bells ringing’ for UK economyBBC News (9/8/17)
- Alistair Darling warns against ‘complacency’ 10 years on from financial crisis
The Telegraph (9/8/17)
- A decade after the financial crisis consumers are still worried
Independent, Kate Hughes (9/8/17)
- Bankers still do not understand complex reasons behind financial crash, senior politician warns
Independent, Ashley Cowburn (9/8/17)
- We let the 2007 financial crisis go to waste
The Guardian, Torsten Bell (9/8/17)
- Bank of England warns of complacency over big rise in personal debt
The Guardian, Larry Elliott (24/7/17)
- On the 10th anniversary of the global financial meltdown, here’s what’s changed
USA Today, Kim Hjelmgaard (8/8/17)
- Financial crisis: Ten years ago today the tremors started
Irish Times (9/8/17)
- If We Are Racing to the Pre-Crisis Bubble, Here Are 12 Charts To Watch
Bloomberg, Sid Verma (9/8/17)
Videos
Questions
- Explain what are meant by ‘collateralised debt obligations (CDOs)’.
- What part did CDOs play in the financial crisis of 2007–8?
- In what ways is the current financial situation similar to that in 2007–8?
- In what ways is it different?
- Explain the Basel III banking regulations.
- To what extent has the Bank of England exceeded the minimum Basel III requirements?
- Explain what is meant by ‘stress testing’ the banks? Does this ensure that there can never be a repeat of the financial crisis?
- Why is it desirable for central banks eventually to raise interest rates to a level of around 2–3%? Why might it be difficult for central banks to do that?
On the 15th June, the Bank of England’s Monetary Policy Committee decided to keep Bank Rate on hold at its record low of 0.25%. This was not a surprise – it was what commentators had expected. What was surprising, however, was the split in the MPC. Three of its current eight members voted to raise the rate.
At first sight, raising the rate might seem the obvious thing to do. CPI inflation is currently 2.9% – up from 2.7% in April and well above the target of 2% – and is forecast to go higher later this year. According to the Bank of England’s own forecasts, even at the 24-month horizon inflation is still likely to be a little above the 2% target.
Those who voted for an increase of 0.25 percentage points to 0.5% saw it as modest, signalling only a very gradual return to more ‘normal’ interest rates. However, the five who voted to keep the rate at 0.25% felt that it could dampen demand too much.
The key argument is that inflation is not of the demand-pull variety. Aggregate demand is subdued. Real wages are falling and hence consumer demand is likely to fall too. Thus many firms are cautious about investing, especially given the considerable uncertainties surrounding the nature of Brexit. The prime cause of the rise in inflation is the fall in sterling since the Brexit vote and the effect of higher import costs feeding through into retail prices. In other words, the inflation is of the cost-push variety. In such cirsumstances dampening demand further by raising interest rates would be seen by most economists as the wrong response. As the minutes of the MPC meeting state:
Attempting to offset fully the effect of weaker sterling on inflation would be achievable only at the cost of higher unemployment and, in all likelihood, even weaker income growth. For this reason, the MPC’s remit specifies that, in such exceptional circumstances, the Committee must balance any trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity.
The MPC recognises that the outlook is uncertain. It states that it stands ready to respond to circumstances as they change. If demand proves to be more resilient that it currently expects, it will raise Bank Rate. If not, it is likely to keep it on hold to continue providing a modest stimulus to the economy. However, it is unlikely to engage in further quantitative easing unless the economic outlook deteriorates markedly.
Articles
The Bank of England is moving closer to killing the most boring chart in UK finance right now Business Insider, Will Martin (16/6/17)
UK inflation hits four-year high of 2.9% Financial Times, Gavin Jackson and Chloe Cornish (13/6/17)
Surprise for markets as trio of Bank of England gurus call for interest rates to rise The Telegraph, Szu Ping Chan Tim Wallace (15/6/17)
Bank of England rate setters show worries over rising inflation Financial TImes, Chris Giles (15/6/17)
Three Bank of England policymakers in shock vote for interest rate rise Independent, Ben Chu (15/6/17)
Bank of England edges closer to increasing UK interest rates The Guardian, Katie Allen (15/6/17)
Bank of England doves right to thwart hawks seeking interest rate rise The Guardian, Larry Elliott (15/6/17)
Haldane expects to vote for rate rise this year BBC News (21/6/17)
Bank of England documents
Monetary policy summary Bank of England (15/6/17)
Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 14 June 2017 Bank of England (15/6/17)
Inflation Report, May 2017 Bank of England (11/5/16)
Questions
- What is the mechanism whereby a change in Bank Rate affects other interest artes?
- Use an aggregate demand and supply diagram to illustrate the difference between demand-pull and cost-push inflation.
- If the exchange rate remains at around 10–15% below the level before the Brexit vote, will inflation continue to remain above the Bank of England’s target, or will it reach a peak relatively soon and then fall back? Explain.
- For what reason might aggregate demand prove more buoyant that the MPC predicts?
- Would a rise in Bank Rate from 0.25% to 0.5% have a significant effect on aggregate demand? What role could expectations play in determining the nature and size of the effect?
- Why are real wage rates falling at a time when unemployment is historically very low?
- What determines the amount that higher prices paid by importers of products are passed on to consumers?
One of President Trump’s main policy slogans has been ‘America first’. As Trump sees it, a manifestation of a country’s economic strength is its current account balance. He would love the USA to have a current account surplus. As it is, it has the largest current account deficit in the world (in absolute terms) of $481 billion in 2016 or 2.6% of GDP. This compares with the UK’s $115bn or 4.4% of GDP. Germany, by contrast, had a surplus in 2016 of $294bn or 8.5% of GDP.
However, he looks at other countries’ current account surpluses suspiciously – they may be a sign, he suspects, of ‘unfair play’. Germany’s surplus of over $50bn with the USA is particularly in his sights. Back in January, as President-elect, he threatened to put a 35% tariff on imports of German cars.
In practice, Germany is governed by eurozone rules, which prevent it from subsidising exports. And it does not have its own currency to manipulate. What is more, it is relatively open to imports from the USA. The EU imposes an average tariff of just 3% on US imports and importers also have to add VAT (19% in the case of Germany) to make them comparably priced with goods produced within the EU.
So why does Germany have such a large current account surplus? The article below explores the question and dismisses the claim that it’s the result of currency manipulation or discrimination against imports. The article states that the reason for the German surplus is that:
… it saves more than it invests. The correspondence of savings minus investment with exports minus imports is not an economic theory; it’s an accounting identity. Germans collectively spend less than they produce, and the difference necessarily shows up as net exports.
But why do the Germans save so much? The answer given is that, with an aging population, Germans are sensibly saving now to support themselves in old age. If Germany were to reduce its current account surplus, this would entail either the government reducing its budget surplus, or people reducing the amount they save, or some combination of the two. This is because a current account surplus, which consists of exports and other incomes from abroad (X) minus imports and any other income flowing abroad (M), must equal the surplus of saving (S) plus taxation (T) over investment (I) plus government expenditure (G). In terms of withdrawals and injections, given that:
I + G + X = S + T + M
then, rearranging the terms,
X – M = (S + T) – (I + G).
If German people are reluctant to reduce the amount they save, then an alternative is for the German government to reduce taxation or increase government expenditure. In the run-up to the forthcoming election on 24 September, Chancellor Merkel’s centre-right CDU party advocates cutting taxes, while the main opposition party, the SPD, advocates increasing government expenditure, especially on infrastructure. The article considers the arguments for these two approaches.
Article
The German economy is unbalanced – but Trump has the wrong answer The Guardian, Barry Eichengreen (12/5/17)
Data
German economic data (in English) Statistisches Bundesamt (Federal Statistical Office)
World Economic Outlook Databases IMF
Questions
- Why does Germany have such a large current account surplus?
- What are the costs and benefits to Germany of having a large current account surplus?
- What is meant by ‘mercantilism’? Why is its justification fallacious?
- If Germany had its own currency, would it be a good idea for it to let that currency appreciate?
- What are meant by ‘resource crowding out’ and ‘financial crowding out’? Why might the policies of tax cuts advocated by the CDU result in crowding out? What form would it take and why?
- Compare the relative benefits of the policies advocated by the CDU and SPD to reduce Germany’s budget surplus.
- Would other countries, such as the USA, benefit from a reduction in Germany’s current account surplus?
- Is what ways would the USA gain and lose from restricting imports from Germany? Would it be a net gain or loss? Explain.
