Sales during the weeks leading up to Christmas often make a significant contribution to retailers’ profits. For many consumers, it is a time to spend money on food, presents and decorations and this often means increased borrowing.
Data indicate that borrowing by consumers in the lead-up to Christmas increased by the biggest amount for almost 8 years: a figure of £1.5 billion. As a result, there were likely to have been many happy families at Christmas, with lots of gifts being exchanged. But what does this mean for the New Year? There are concerns about the increase we will see in consumer debt throughout 2016 and the number of borrowers who will, perhaps, be unable to repay their debts.
Could this significant increase in borrowing be a signal that we haven’t learnt from our past? This article from BBC News considers the borrowing data and their implications.
Borrowing jumped ahead of Christmas, Bank of England says BBC News, Brian Milligan (4/01/16)
Questions
- Is borrowing good or bad for the economy? Explain your answer.
- If borrowing is good for the economy, why are there concerns about the current level of borrowing?
- How will this higher level of borrowing affect aggregate demand? Use an AD/AS diagram to explain the impact this will have.
- Could this higher level of borrowing affect unemployment and inflation? In what ways?
- If interest rates had been higher, do you think the level of consumer borrowing would have been lower?
To what extent does history repeat itself? Minsky’s Financial Instability Hypothesis infers that credit cycles are fairly inevitable. We have seem them in the past and we will see them in the future. Human beings are subject to emotion, to irrational exuberance and to a large dose of forgetfulness! To what extent do the latest UK credit numbers suggest that we might be embarking on another credit binge? Are the credit data consistent with evidence of another credit cycle?
Chart 1 shows the stocks of debt acquired by households and private non-financial corporations from MFIs (Monetary Financial Institutions). The scale of debt accumulation in the late 1980s and again from the mid 1990s up to the financial crisis of the late 2000s is stark. At the start of 1985 the UK household sector had debts to MFIs of around £140 billion. By the start of 2009 this had hit £1.29 trillion. Meanwhile, private non-financial corporations saw their debts to MFIs rise from around £45 billion to over £500 billion. (Click here to download a PowerPoint of the chart.)
The path of debt at the start of the 2010s is consistent with a story of consolidation. Financially-distressed households, private non-financial corporations and, of course, MFIs themselves meant that corrective action was needed to repair their balance sheets. The demand for and supply of additional credit waned. Debt accumulation largely ceased and, in fact, debt numbers fell. This trend continues today for private non-financial corporations. But, for households debt accumulation resumed in the middle of 2013. At the end of the third quarter of 2015 the household sector had debt obligations to MFIs of £1.246 trillion.
Chart 2 focuses on flows rather stocks. It allows us to see the accumulation of new credit (i.e. less repayments of debt). What is even more apparent from this chart is the evidence of cycles in credit. The growth in new credit during the 2000s is stark as is the subsequent squeeze on credit that followed.
The question that follows is what path are we now on? Clearly flows of credit to households are again on the rise. In part, this is driven by the rebound in the UK housing market. But, in fact there is a more rapid increase in consumer credit, i.e. unsecured debt. (Click here to download a PowerPoint of the chart.)
Chart 3 shows the flows of consumer credit from MFIs and other credit providers. Again, we see the marked evidence of cycles. In the year to the end of Q1 of 2015 net consumer credit flows amounted to £22.8 billion, the highest figure since the 12-month period up to the end of Q3 of 2005. Click here to download a PowerPoint of the chart.)
While it might be a little early to say that another Minsky cycle is well under way, policymakers will be keeping a keen eye on credit patterns. Is history repeating itself?
Articles
Average UK mortgage debt rises to £85,000 The Guardian, Phillip Inman (15/12/15)
Consumer spending rise troubles Bank of England The Guardian, Heather Stewart (24/11/15)
Recovery ‘too reliant on consumer debt’ as BCC downgrades forecast The Guardian, Heather Stewart (9/12/15)
BCC: UK Growth Too Reliant On Consumer Debt Sky News (9/12/15)
Interest rates will stay low for longer – but household debt is a worry, says BoE The Telegraph, Szu Ping Chan (24/11/15)
IMF: UK’s economic performance ‘very strong’, but risks remain BBC News (11/12/15)
Data
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database Bank of England
Questions
- How can the financial system affect the economy’s business cycle?
- What does it mean if households or firms are financially distressed? What responses might they take to this distress and what might the economic consequences be?
- How would you measure the net worth (or wealth) of an individual or a firm? What factors might affect their net worth?
- How might uncertainty affect spending and saving by households and businesses?
- What does it mean if bank lending is pro-cyclical?
- Why might lending be pro-cyclical?
- Are there measures that policymakers can take to reduce the likelihood that flows of credit become too excessive?
As we saw in the blog post Down down deeper and down, or a new Status Quo?, for many countries there is now a negative rate of interest on bank deposits in the central bank. In other words, banks are being charged to keep liquidity in central banks. Indeed, in some countries the central bank even provides liquidity to banks at negative rates. In other words, banks are paid to borrow!
But, by definition, holding cash (in a safe or under the mattress) pays a zero interest rate. So why would people save in a bank at negative interest rates if they could get a zero rate simply by holding cash? And why would banks not borrow money from the central bank, if borrowing rates are negative, hold it as cash and earn the interest from the central bank?
These questions are addressed in the article below from The Economist. It argues that to swap reserves for cash is costly to banks and that this cost is likely to exceed the interest they have to pay. In other words, there is not a zero bound to central bank interest rates, either for deposits or for the provision of liquidity; and this reflects rational behaviour.
But does the same apply to individuals? Would it not be rational for banks to charge customers to deposit money (a negative interest rate)? Indeed, there is already a form of negative interest rate on many current accounts; i.e. the monthly or annual charge to keep the account open. But would it also make sense for banks to offer negative interest rates on loans? In other words, would it ever make sense for banks to pay people to borrow?
Read the folowing article and then try answering the questions.
Article
Bankers v mattresses The Economist (28/11.15)
Central bank repo rates/base rates
Central banks – summary of current interest rates global-rates.com
Worldwide Central Bank Rates CentralBankRates
Questions
- What is a central bank’s ‘repo rate’. Is it the same as (a) its overnight lending rate; (b) its discount rate?
- Why are the Swedish and Swiss central banks charging negative interest rates when lending money to banks?
- What effect are such negative rates likely to have on (a) banks’ cash holdings; (b) banks’ lending to customers?
- Why are many central banks (including the ECB) charging banks to deposit money with them? Why do banks continue to make such deposits when interest rates are negative?
- Would banks ever lend to customers at negative rates of interest? Explain why or why not.
- Would banks ever offer negative rates of interest on savings accounts? Explain why or why not.
- How do expectations about exchange rate movements affect banks willingness to hold deposits with the central bank?
- What are the arguments for and against abolishing cash altogether?
George Osborne in his recent Autumn Statement, once again stressed that ‘the government is committed to strong, sustainable and balanced growth’. But while he plans to reduce government debt as a percentage of GDP, consumer debt is rising, both absolutely and as a percentage of household disposable income. The rise in household borrowing, and the resulting rise in consumer expenditure, has been the main factor driving economic growth. It has not been exports nor, until recently, investment, as the Chancellor had hoped. Indeed, investment in new housing is falling.
The Office for Budget Responsibility in its latest Economic and Fiscal Outlook forecasts that gross household debt will reach 163 per cent of household disposable income by 2021, up from 146% at the end of 2015.
Consumer gross debt includes both secured debt and unsecured debt. Secured debt is essentially debt secured on property (i.e. mortgages), while unsecured debt is largely in the form of credit card debt, overdrafts and personal loans.
The chart shows that from 2008 to 2013, gross debt fell as a percentage of personal disposable income. Following the financial crisis, banks were more cautious about lending as they sought to increase their capital and liquidity ratios. And consumers were more cautious about borrowing as the uncertainty made many people keen to reduce their debts. This decline in credit reversed the massive growth in household debt from 2000 to 2008: one of the contributing factors to the financial crisis. (Click here for a PowerPoint of the chart.)
But since late 2013, household debt – both secured and unsecured – has been rising. In absolute (nominal) terms, individuals’ debt is now £1.43 trillion, slightly above the previous high in 2008. And as the chart shows, the OBR forecasts that it will continue rising. This makes consumers more vulnerable to adverse economic shocks, such as a downturn in emerging markets, another crisis in the eurozone or financial crises in other parts of the world.
And as consumer debt has been rising, the personal saving ratio (the ratio of saving to personal disposable incomes) has been falling and is now lower than before the financial crisis.
The rise in consumer borrowing has been of some concern to the Bank of England. Andy Haldane, the Bank’s Chief Economist, appearing before the Treasury Select Committee, warned that consumer credit, and in particular personal loans, had been ‘picking up at a rate of knots. That ultimately might be an issue that the Financial Policy Committee might want to look at fairly carefully.’
Articles
The UK economy may be growing, but in a highly unbalanced way The Guardian, Phillip Inman (27/11/15)
UK growth hit by biggest drag from net trade on record The Telegraph, Szu Ping Chan (27/11/15)
Surge in consumer lending could prompt Bank of England intervention The Guardian, Patrick Collinson and Jill Treanor (30/11/15)
Consumer spending rise troubles Bank of England The Guardian, Heather Stewart (24/11/15)
Between Debt and the Devil by Adair Turner review – should the government start printing money? The Guardian, Tom Clark (25/11/15)
Lending rises as Bank of England ponders new curbs Financial Times, Ferdinando Giugliano (30/11/15)
Carney indicates BoE’s willingness to rein in credit Financial TImes, Chris Giles (5/11/15)
FCA sounds alarm at rising credit card debt Financial Times, Emma Dunkley (3/11/15)
Interest rates will stay low for longer – but household debt is a worry, says BoE The Telegraph, Szu Ping Chan (24/11/15)
Seven years after the crisis, Britain is still addicted to the drug of debt Independent, James Moore (1/12/15)
Vince Cable: Former Business Secretary warns that ‘severe economic storms’ are on the way Independent, Ben Chu (14/11/15)
The risks stalking the UK economy BBC News, Kamal Ahmed (1/12/15)
OBR publications
Economic and fiscal outlook Office for Budget Responsibility (25/11/15)
Economic and fiscal outlook charts and tables (Excel file) Office for Budget Responsibility (25/11/15)
Questions
- Does it matter if economic growth is driven by a rise in consumer demand, in turn driven by a risen in consumer credit?
- Is there an inflation risk from growth being driven by a rise in consumer credit?
- What is the precise relationship between the household saving ratio and the household debt ratio? (Which of these ratios is a stock and which is a flow?)
- What might cause a fall in consumer borrowing? Would this be a good thing?
- Why did consumer borrowing fall following the financial crisis of 2007–8?
- What could the Bank of England’s Financial Policy Committee do to curb consumer borrowing?
- If banks were forced to hold more reserves, how could aggregate demand be maintained? Would ‘helicopter money’ be a good idea?
- What are ‘countercyclical buffers for banks’? What are the arguments for raising them at the current time?
It is now some seven years since the financial crisis and nearly seven years since interest rates in the USA, the eurozone, the UK and elsewhere have been close to zero. But have these record low interest rates and the bouts of quantitative easing that have accompanied them resulted in higher or lower investment than would otherwise have been the case? There has been a big argument about that recently.
According to conventional economic theory, investment is inversely related to the rate of interest: the lower the rate of interest, the higher the level of investment. In other words, the demand-for-investment curve is downward sloping with respect to the rate of interest. It is true that in recent years investment has been low, but that, according to traditional theory, is the result of a leftward shift in demand thanks to low confidence, not to quantitative easing and low interest rates.
In a recent article, however, Michael Spence (of New York University and a 2001 Nobel Laureate) and Kevin Warsh (of Stanford University and a former Fed governor) challenge this conventional wisdom. 
According to them, QE and the accompanying low interest rates led to a rise in asset prices, including shares and property, rather than to investment in the real economy. The reasons, they argue, are that investors have seen good short-term returns on financial assets but much greater uncertainty over investment in physical capital. Returns to investment in physical capital tend to be much longer term; and in the post-financial crisis era, the long term is much less certain, especially if the Fed and other central banks start to raise interest rates again.
“We believe that QE has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose ‘shareholder friendly’ share buybacks over investment in a new factory. But public policy shouldn’t bias investments to paper assets over investments in the real economy.”
This analysis has been challenged by several eminent economists, including Larry Summers, Harvard Economics professor and former Treasury Secretary. He criticises them for confusing correlation (low investment coinciding with low interest rates) with causation. As Summers states:
“This is a little like discovering a positive correlation between oncologists and cancer and asserting that this proves oncologists cause cancer. One would expect in a weak recovery that investment would be weak and monetary policy easy. Correlation does not prove causation. …If, as Spence and Warsh assert, QE has raised stock prices, this should tilt the balance toward real investment.”
Not surprisingly Spence and Warsh have an answer to this criticism. They maintain that their critique is less of low interest rates but rather of the form that QE has taken, which has directed new money into the purchase of financial assets. This then has driven further asset purchases, much of it by companies, despite high price/earnings ratios (i.e. high share prices relative to dividends). As they say:
“Economic theory might have something to learn from recent empirical data, and from promising new thinking in behavioral economics.”
Study the arguments of both sides and try to assess their validity, both theoretically and in the light of evidence.
Articles
The Fed Has Hurt Business Investment The Wall Street Journal, Michael Spence and Kevin Warsh (26/10/15) [Note: if you can’t see the full article, try clearing cookies (Ctrl+Shift+Delete)]
I just read the ‘most confused’ critique of the Fed this yea Washington Past, Lawrence H. Summers (28/10/15)
A Little Humility, Please, Mr. Summers The Wall Street Journal, Michael Spence and Kevin Warsh (4/11/15) [Note: if you can’t see the full article, try clearing cookies (Ctrl+Shift+Delete)]
Do ultra-low interest rates really damage growth? The Economist (12/11/15)
It’s the Zero Bound Yield Curve, Stupid! Janus Capital, William H Gross (3/11/15)
Is QE Bad for Business Investment? No Way! RealTime Economic Issues Watch, Joseph E. Gagnon (28/10/15)
Department of “Huh!?!?”: QE Has Retarded Business Investment!? Washington Center for Equitable Growth, Brad DeLong (27/10/15)
LARRY SUMMERS: The Wall Street Journal published the ‘single most confused analysis’ of the Fed I’ve read this year Business Insider, Myles Udland (29/10/15)
The Fed’s Loose Money, Financial Markets and Business Investment SBE Council, Raymond J. Keating (29/10/15)
How the QE trillions missed their mark AFR Weekend, Maximilian Walsh (4/11/15)
Financial Markets In The Era Of Bubble Finance – Irreversibly Broken And Dysfunctional David Stockman’s Contra Corner, Doug Noland (8/11/15)
Questions
- Go through the arguments of Spence and Warsh and explain them.
- Explain what are meant by the ‘yield curve’ and ‘zero bound yield curve’.
- What criticisms of their arguments are made by Summers and others?
- Apart from the effects of QE, why else have long-term interest rates been low?
- In the light of the arguments on both sides, how effective do you feel that QE has been?
- How could QE have been made more effective?
- What is likely to happen to financial markets over the coming months? What effect is this likely to have on the real economy?
Sales during the weeks leading up to Christmas often make a significant contribution to retailers’ profits. For many consumers, it is a time to spend money on food, presents and decorations and this often means increased borrowing.
