Some Tolstoyan advice for the UK on debt

Unindebted countries are all alike; overindebted countries are overindebted in their own way

By Martin Wolf

The UK’s debt problem has been exaggerated. That was the thesis of a provocative speech on “deleveraging” by Ben Broadbent, a member of the Bank of England’s Monetary Policy Committee, in March. Is this convincing? What does it imply?
Nobody now doubts that financial crises cast long shadows on economies: recessions are deep and recoveries are weak. This is the lesson to be drawn from the seminal work of Carmen Reinhart at the Peterson Institute in Washington and Kenneth Rogoff of Harvard University. The UK has learnt this well: it is suffering a longer and costlier depression – a period when output remains below the previous peak – than it did in the 1930s. Moreover, nobody doubts that, in Mr Broadbent’s words, “almost all financial crises are preceded by rapid growth in credit”. But, he adds, “I am not convinced that, as a general matter, non-financial domestic leverage was the key reason for the UK’s financial crisis or, therefore, that it needs to return to some historical ‘norm’ for us to declare the crisis at a definitive end.”

If I were to summarise Mr Broadbent’s view, it would be with a paraphrase of Tolstoy: 

“Unindebted countries are all alike; overindebted countries are overindebted in their own way.” 

What matters is who owes what to whom: if debtors are solvent and liquid, problems are small. If they are not, they are large.

If Mr Broadbent were right, this would be good news, since the UK’s indebtedness is among the world’s highest: according to the McKinsey Global Institute, in the second quarter of 2011, gross debt was 507 per cent of gross domestic product, against just 279 per cent in the US. Within this total, household debt was 98 per cent of GDP, against 87 per cent in the US, and non-financial corporate debt was 109 per cent of GDP, against 72 per cent in the US.

In the case of the UK, argues Mr Broadbent, the characteristics of debtors are relatively favourable, with a few exceptions: lending to commercial real estate and unsecured lending to households was excessive, risky and damaging. The exposure of UK banks to overseas assets was also risky: “Overall, around three-quarters of the losses of UK banks have been incurred on their non-UK assets,” he emphasises.

Mr Broadbent makes three points. First, the rise in the price of housing and the consequent leveraging of the household balance sheets was driven not by excessive credit but by the fall in the long-term risk-free rate of interest. Second, bank losses on domestic assets have been small: astonishingly, “the major UK-owned banks have lost around 15 times as much on non-UK mortgages what they have in the domestic market”. Finally, the evidence linking debt and growth is mixed.

The first and second points are persuasive. The ability of people to bear debt depends on the value of their assets. In the US, real house prices have fallen 41 per cent from their peak, according to the S&P Case-Shiller index. In the UK, the fall has been just 17 per cent, according to the LSL Acadametrics index. The biggest difference, however, is that the US built houses; the UK hardly did. So the rise in US house prices was unsustainable; in the UK, it may be. Yet the UK also had no equivalent of subprime lending, while a relatively robust safety net supports incomes.

The fact that the UK housing market has proved robust is crucial to Mr Broadbent’s optimism. In this context, a comparative analysis of housing booms and busts in the latest World Economic Outlook from the International Monetary Fund is sobering: it asserts, plausibly, that “housing busts and recessions preceded by large run-ups in household debt tend to be more severe and protracted”. Moreover, “it seems to be the combination of house price declines and pre-bust leverage that explains the severity of the contraction, in particular, household consumption falls by more than four times the amount that can be explained by the fall in house prices in high-debt countries”.

Mr Broadbent is right: it is unnecessary for the rise in UK household debt to be reversed. But debt makes the economy vulnerable to worse unemployment, falling house prices or higher interest rates.

Moreover, this argument raises the question of why the UK recovery has been far weaker than that of the US, which has suffered a bigger collapse in house prices and a worse domestic debt problem. Adam Posen, another member of the MPC, addressed this question in a speech in March, on “Why is their recovery better than ours?”. The conclusion was that US consumption and investment were both more robust. One reason for the former is that inflation has been higher in the UK. But the compelling point is that fiscal policy has been significantly tighter: one reaps what one sows, in other words.

It is comforting to know that the economy could be doing far better. It is not so comforting that it is not.