It’s the private debt, stupid

It’s the private debt, stupid

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by Marcel Canoy & Robin Fransman

Rotten luck for the Underwater family in Stonehouse Gloucestershire. They bought their house in 2007 with a pretty heavy mortgage, like most people at the time. Too bad that the value of their house dropped by 12%. To add insult to injury, Robert Underwater lost his job and failed to get a new one. A serious debt issue is looming.

The Underwaters are not alone in this. Whilst the evidence that private debt is a much bigger issue than government debt is overwhelming, governments throughout Europe do precious little to address the problem. Private debt across Europe is twice the size of sovereign debt, while interest rates are also much higher.

Private Debt Eurozone % GDP, Source: Eurostat

Austerity measures may have managed to create budgetary discipline, but without a resolution of private debt there is little hope of avoiding the Japanese scenario of low growth, deflation flirts and stubbornly high unemployment. Recent recovery messages cannot hide the inherent vulnerability of Europe to private debt. Without a credible way of restoring final demand through private debt resolution, today’s positivity can easily become tomorrow’s gloom.   

To curb the vicious circle we need to address the problem of the Underwaters. We suggest three layers of debt resolution mechanism.  If the Underwaters are still able to repay part of their debt and there is hope for job renewal, debt can be swapped for equity, just as in regular business practice. Experience in Ireland where houses are sold to banks, resold to building societies and rented out to the previous owners can be spread to other parts of Europe. It leads to a much smoother process than current practices and is incentive compatible. It is also much better than the U.K.’s ‘Help to Buy’ scheme that exacerbates problems because of the spill-over effects to the rest of the housing market. Countries with mandatory pension schemes could implement the Swiss system where pension premiums and/or pension capital can be used to pay down the mortgage. The pension losses are offset by the mortgage-free house.

With more bad luck on the job market, the Underwaters face tougher problems. A more drastic step may be needed. Remitting part of debt can be both in the interest of the Underwaters and the banks. Remittance is treated as a curse word by liberals, allegedly because it creates moral hazard issues.  But if the Underwaters are primarily in trouble due to circumstances beyond their control, moral hazard issues are of little consequence. High unemployment and queues at the food bank are clearly far bigger moral issues. Partial remittance can be ethically sound, saving the bank a long and cumbersome liquidation process, whilst preserving the Underwaters as happy clients. The remittance could take the form of lowering the nominal debt, or lowering the interest rate.

If equity debt swaps and partial remittance are unsuitable, bankruptcy is unavoidable. In most European countries personal bankruptcy is an extremely cumbersome and long-winded process that seems to be geared towards punishment and shame. Whilst the punishment methods have become more civilized than mediaeval methods such as hanging, the inherent logic has stayed the same. We plead for a more forward looking resolution mechanism for personal bankruptcy, with a better articulated division of responsibilities between society as a whole and those in trouble. After all, it is economically insane and unnecessarily humiliating to punish the Underwaters for many years if their trouble is basically business-cycle related.

There are a lot of Underwaters in Europe, who are – often due to circumstances beyond their control - victims of the crisis and are exposed to unsatisfactory debt resolution mechanisms. Europe can muddle through with austerity and the tweaking of banking supervision for years to come. But an economy with high private debt is fundamentally unsound. Inefficient and socially unacceptable debt resolution practices must be traded for superior, faster and more humane procedures. The debt of the Underwaters from Stonehouse Gloucestershire affects us all.


Marcel Canoy is chief economist at Ecorys, a Dutch-UK based consultancy, and writes columns for Het Financieele Dagblad in the Netherlands. Robin Fransman is Deputy Director of the Holland Financial Centre.


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In the UK there is a solution, short of bankruptcy, for the Underwaters and others genuinely struggling to repay their debt: it is called an Individual Voluntary Arrangement which involves the debtor repaying as much as he/she reasonably can do and cancels all future interest and wipes out the balance after 5 years if he/she lives up to his/her side of the deal. It also takes into account the ability to swap any additional equity in the house if house prices rise during the five years for part/all of the remaining debt (net of agreed write-offs). Over the 8 years 2006-13 368,000 people, over 1% of the adult population of England & Wales*, have taken out an IVA.
Reasonable article but C- for homework
* There is a similar scheme in Scotland called a Protected Trust Deed.

No, the real “stupids” are Marcel Canoy and Robin Fransman (if we’re going to use the word stupid).

First, their chart seems to show private debts rising from about 150% of GDP in 2000 to roughly 200% now. That’s not a catastrophic rise.

Second, they give no objective reason for thinking 200% rather than 300% or 100% is some sort of dividing line between acceptable and disastrous debt levels.

Third, they say “but without a resolution of private debt there is little hope of avoiding the Japanese scenario of low growth, deflation flirts and stubbornly high unemployment.” Really? So what’s to stop government simply raising demand and cutting unemployment? They don’t say.

But I know exactly what they think. Given their claim that “Austerity measures may have managed to create budgetary discipline..” it’s obvious that they haven’t got the distinction between macroeconomics and microeconomics. I suggest they read Ann Pettifor’s work “The Economic Consequences of Mr Osborne”. That work explains why spending cuts have no effect on the budget deficit. I.e. austerity achieves nothing. That is, contrary to popular belief, “austerity measures” have no effect on “budgetary discipline”.

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