The Stocks and the Flows
There has been considerable pressure in recent months for the Bank of England to start raising interest rates. Some argue that interest rate rises are needed to control the housing market, especially in London and the South East. And others argue for interest rate rises to "get people used" to the idea that rates will be higher, discouraging risky lending and encouraging people to think about the affordability of debt service in the future. Avoiding another credit bubble and financial crash is on everyone's mind.
They have a point. London and South East prices have been rising fast, though the pace of increase appears to be slowing. And a significant proportion of new mortgages are at high income multiples (4.5x or more), which are at the limits of affordability. But the Bank of England's Governor, Mark Carney, has made it clear that prudential regulation is the preferred approach to limiting the growth of high-risk mortgage lending, and the Chancellor has recently extended the powers of to prudential regulators. Prudential regulation is untested in the UK as a primary means of controlling the housing market, and for this reason some worry that it will not be effective. But early signs are encouraging: mortgage lending has actually fallen in recent months due to tighter lending standards recently imposed by the FCA.
The growth of the housing
market is not likely to trigger interest rate rises. But improving
economic conditions in the UK suggest that interest rates might need
to rise fairly soon, perhaps within the next year. This would benefit
those people who have suffered from the very low interest rates in
recent years, particularly pensioners on fixed incomes. But it could
have disastrous effects on another group – highly-indebted
home owners on low-to-middle incomes.
In an excellent new
report, the Resolution Foundation discusses the impact on
households of forthcoming interest rate rises. They distinguish
between two groups:
the “flows” of new borrowers
the “stock” of existing borrowers
The Resolution Foundation agrees that
the propensity of new borrowers to borrow more than they can afford
does need to be managed. But it supports the Bank of England's view
that macroprudential and conduct regulation is the right approach,
not monetary policy. If macroprudential and conduct regulation is
both appropriate and enforced, interest rises should not cause major
problems for new borrowers.
But the same cannot be said of existing borrowers. Household debt is still over 90% of GDP, only slightly down from its peak of 102% in 2009:
The Resolution Foundation's principal concern is that a high proportion of iindebted households are over-extended because of falling real incomes, unemployment, under-employment and widening credit spreads. If interest rates start to rise, they could be at serious risk. Modelling a rise in the base rate to 3% by 2018, which is consistent with Bank of England guidance, they find the following:
The number of households spending more than a third of their after-tax income on mortgage debt service would rise from 1.1m to 2.3m. That is a quarter of all households with mortgages.
The number of households spending more than half of their after-tax income on all forms of debt repayments would nearly double, from 0.6 million to 1.1 million.
This presents a considerable problem for policy makers (their
The sequencing of rate rises and
the pace and spread of household income growth in the coming years
will be crucial. The problem is complicated by the fact that
policy makers must simultaneously have regard for both the stock
of existing borrowers and the flow of new entrants. Ensuring we
learn the lessons of the past means tightening lending criteria and
reducing the economy’s dependence on debt; yet moving too hard in
this direction risks adding to the affordability problems faced by
members of the stock who were lent to at a time when credit was much
looser. A one-size fits all approach is unlikely to be appropriate.
It is all too easy for those who would benefit from rate rises to argue that existing borrowers have had years of forbearance and it is time for them to “man up” and accept the consequences of their folly. But many of the home owners who would suffer from ill-considered rate rises are not profligate: they borrowed within their means to buy modest houses, but because of the financial crises and the ensuing recession they have suffered unemployment, under—employment and falling real incomes, which have turned reasonable debt commitments into living nightmares.
Bank of England data shows that despite historically low base rates, 18.6% of households report having difficulty paying their mortgages:
It is simply ridiculous to assume that nearly a fifth of all households with mortgages borrowed irresponsibly. A
minority no doubt did – though it is worth remembering that for
people with stable incomes but little in the way of savings, a
subprime high-LTV mortgage can be a good choice and doesn't mean
either they or the lender are irresponsible. But the rest have
simply been victims of circumstances. Do they really deserve to lose
It seems likely that if base rates had
remained at the level they were in 2007 – or worse, at the
level they were in 1991 at the height of the last mortgage crisis –
mortgage payment difficulties would be even more prevalent. And it also seems evident that raising rates now is highly risky
while household balance sheets remain so fragile. Policy makers must proceed with great caution.
The Resolution Foundation concludes
that the debt overhang must be dismantled. And I concur, for two
reasons. The first, obviously, is the fact that while households
remain over-leveraged, interest rate rises threaten both economic
growth and financial stability, since households will be forced to
cut spending to meet higher interest payments and a rising proportion
of them will end up defaulting. As Mark
Carney observed in his speech at the opening of the Commonwealth
Games, the UK's households are very sensitive to income shocks, and
the consequences for the economy could be serious:
History shows that the British
people do everything they can to pay their mortgages. That means
cutting back deeply on expenditures when the unexpected happens. If a
lot of people are highly indebted, that could tip the economy into
It's worth remembering, too, that high
interest rates when nominal incomes are stagnant make paying off debt
more difficult, as money that might have gone into debt repayment
goes into higher interest payments instead. But there is also a risk
that holding rates down for too long would cause distortions and
misallocations that require far more aggressive tightening later on.
When, and by how much, to raise rates is extraordinarily difficult to
determine when household leverage is high. Reducing it before
raising rates significantly seems sensible.
But my second reason for acting to
dismantle the household debt overhang is perhaps more subtle.
Households that are only just managing to afford debt repayments will go without treats for the kids, lunch with friends, doing up the house, going on holiday or replacing worn-out or broken household items. It's amazing what people will live without in order to ensure they can continue to pay their mortgages. But when discretionary spending is curtailed by a large proportion of households, the businesses that provide these goods and services are forced to cut prices and retrench. This causes wages to stagnate or fall, making debt service more difficult and forcing indebted households to maintain or even increase household austerity. At present real incomes are falling and inflation is low, which suggests that aggregate demand is still deficient despite six years of low interest rates and QE: it seems likely that the household debt overhang is at least partly responsible for this. Even without the risk of interest rate rises, therefore, reducing or eliminating the household debt overhang would be a far more effective demand stimulus than QE has ever been.
The Resolution Foundation comes up with
a number of approaches to restructuring household debt burdens,
grouped under three broad policy themes:
(a larger version of this chart can be found here)
These policy recommendations can be
summarised in relation to the timing of interest rate rises:
- Interest rates should not rise until
it is clear that there is broad-based recovery, including rising
incomes among the most highly indebted households. This
requires a distributional analysis that the Bank of England's data
sources currently cannot provide. There is therefore an urgent need
to improve the information and analysis available to policy makers.
- While interest rates remain low,
highly indebted households should be helped to lock in low interest
rates for the future. Lenders
must identify households most at risk from interest rate rises and
encourage them to refinance at fixed rates. And regulators should discourage lenders from raising margins on existing variable rate mortgages for those unable or unwilling to refinance.
- Before interest rates are raised, quality and availability of debt advice should be improved and debt restructuring programmes extended.
Resolution Foundation's findings are welcome. For the first time they
give clear direction to policy makers about the work that will be
required to enable interest rates to be normalised without risking
debt deflationary collapse. Particularly sensible are their
suggestions for a Government-backed shared ownership scheme to enable
people who need to exit home ownership to do so while remaining in
their homes: and their recommendation that debt restructuring schemes
should incorporate an element of saving for unbudgeted expenditures.
Both of these would do much to reduce the anxiety that many
households feel when faced with income shocks and the prospect of
losing their home.
however concerned that the report focuses almost exclusively on
mortgage debt, when there remain many households whose principal debt
burden is unsecured debt. Rising interest rates on mortgages may
force many of these households into default on unsecured debt. It is
perhaps not widely known that a default on unsecured debt can result
in the debtor losing their home, if the unsecured creditor chooses to recover the debt through the bankruptcy courts. This is
because in bankruptcy, unsecured creditors have a claim on the
debtor's unencumbered assets: if the debtor owns a house on which the
mortgage is less than 100% of the value, the unsecured creditor may
force sale of the house in order to claim the equity in settlement of
the unsecured debt. When credit card defaults were very high after
the financial crisis quite a few lenders chose this method of
recovery. I think regulators should be tasked with ensuring that lenders do not do so again.
And for me the Resolution Foundation's recommendations actually don't go far enough to meet their objective of "dismantling the debt overhang". Household debt at over 90% of GDP is only sustainable while interest rates remain very low, but falling real incomes do not allow households to deleverage at the pace that would be necessary to allow interest rates to rise safely. The Resolution Foundation only briefly mention debt forgiveness, but the reality is that if incomes do not improve, widespread debt forgiveness, rather than restructuring, may be the best option for future economic growth. Despite the improving economy, debt jubilee is not yet off the table.
Interest rate rises in Britain? Not yet - The Economist
The not-so-new (but very uncertain) neutral - Frances Coppola
Image from www.familyweek.net.