Myths and legends of low interest rate policy
There is no doubt that the UK is growing again. The Office for National Statistics estimates year-on-year growth was 1.9% to the end of the third quarter of last year – an improvement that has surprised many commentators (this one included).
With inflation having been stuck above target this return to growth has provided new ammunition to those looking for the Bank of England to begin to push rates back up from their current levels.
Jeremy Warner`s latest in The Telegraph will no doubt elicit cheers from this ever louder, if not significantly larger, group. Warner wants to slay the myths propagated by the low rates crowd that, he says, are privileging the “reckless few” over the hardworking majority. I strongly disagree both with the characterisation of indebted households as “reckless” and with the idea that raising rates offers anything approaching a helpful step for the UK under current conditions.
Let us address each of Warner`s myths in turn and see if they stand up to scrutiny.
1.) “It has become an article of faith among central bankers that balance sheets – particularly household balance sheets – remain too stretched to be able to withstand tighter monetary conditions”
If by faith Warner is here questioning the validity of the available data then he may have some grounds for doubt. Most of the information we have about the state of household finances come from surveys that may arguably not be sufficiently representative. That, however, is a methodological complaint that the Telegraph article does not appear to make.
Instead Warner argues that UK households are not “up to their necks in debt” and that, in fact, they are not high “judged against comparable economies”. Here I pass the mic to the Bank of England in their latest Financial Stability Report released last November:
“UK household and PNFC debt levels remain historically high in aggregate, at around 165% of GDP. As discussed in the June Report, the UK household debt to income ratio has fallen by around 30 percentage points since 2008, as nominal incomes have increased more rapidly than household debt. But the UK household debt to income ratio, of 140%, remains higher than comparable ratios in the euro area and the United States.”
That seems quite clear to me. Households may now only be up to their chests in debt but comparing the UK to Sweden, Norway, the Netherlands, Ireland and Denmark (two of which are fighting signs of housing bubbles and another still dealing with the aftermath of one bursting) seems rather selective in that context.
2.) “[T]he idea that all this housing debt caused the crisis turns out to be another of the myths”
Warner here cites Ben Broadbent`s 2012 speech on Deleveraging in which he states:
“losses on most domestic loans have actually been unexceptional. Instead, it is UK banks’ substantial overseas assets that caused much of the damage. To take one striking example, the major UK-owned banks have lost around 15 times on non-UK mortgages what they have in the domestic market. Overall, around three-quarters of aggregate losses have been on their non-UK balance sheets.”
It is undoubtedly true that UK residential mortgage defaults have been surprisingly low over the financial crisis. But this can be attributed to the success of low interest rate policy driving down mortgage costs for borrowers who would otherwise have struggled with their repayments.
To claim that an effective policy response suggests there was no problem would be dangerous folly. There is very little doubt that a proportion of mortgage lending to UK households in the years leading up to the crisis was unwise. That it was not on the scale of US sub-prime lending is undisputed but it should not be used to imply that there was no issue to begin with.
One way of looking at this is that mortgages are claims on the future incomes of borrowers. In a bubble the prospects for higher future earnings are going to look rosier and therefore lending conditions are likely to be easier. A prolonged recession in which unemployment rises sharply and/or incomes fall will make these assumptions unsound and some borrowers will struggle to meet their repayments. This doesn`t suggest borrowers were being profligate or “reckless”, only that both they and the lenders were over-confident in the continuation of a NICE environment.
The point here is that when rates start to rise we are likely to see the impact of these decisions – but if rates are raised before real incomes start to grow we may inflict unnecessary hardships on those who have suffered as a consequence of the crisis.3.) “we all borrowed too much and so cannot withstand higher interest rates until debt has returned to sustainable levels”
As my colleague Frances Coppola will quickly point out looking at household debt as a percentage of GDP is of limited value as you are comparing a stock (total household debt) with a flow (the output of the economy over a given period). The pertinent question here, however, is whether households can afford the debt that they have, not the total sum of the debt burden.
Warner points out that 42 per cent of households own their properties outright. That is good news for them, but it doesn`t really tell us much about the hazards or lack thereof of raising interest rates. Instead the chart below from a recent Resolution Foundation report might be more helpful:
As the report states, “even under ‘good’ income growth, the number of households with perilous levels of debt rises from 600,000 in 2011 to 1.1 million in 2018. With sharper increases in borrowing costs, the number rises to 1.4 million and 1.7 million – exceeding both its pre-crisis peak and the level set in the early-1990s recession”. If we accept Broadbent`s analysis of the crisis, many of these people will have had their incomes hit as a consequence of the decision by UK banks to lend money abroad and were not borrowing recklessly. To punish them for their bad luck is to compound the injustice.
The Bank`s Financial Stability Report paints an even gloomier picture:
“Partly as a result of these high debt to income ratios, some borrowers have limited income available to absorb shocks. For example, according to the survey, 16% of mortgage debt is owed by households with less than £200 of income remaining per month after housing costs and essential expenditure. And nearly a third of households have less than £300 of income remaining per month after these costs.”
Warner is clearly, and understandably, worried about the possibility of another UK housing bubble. Yet, if so, rather than pushing for a costly rate rise he should be directing his ire at the Coalition`s Help to Buy policy that is attempting to inflate prices into an economic upturn. After all, they are the real reckless few.
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