The Coming Crisis

Credit where Credit is Due

The Bank of England released its statistics on consumer credit yesterday. The figures show consumer credit growing, but at a slower rate than earlier this year. Consumer credit is now growing at an annualised rate of 9.1 per cent — down the peak of 10.9 per cent in November 2016. However, credit card debt, which represents about half of this form of lending, and which is one of the more expensive forms of debt, is accelerating.

The statistical release also included figures on mortgage lending, which is much larger than consumer credit, and much more systemically important to the financial system. These figures showed continued increases in the number and value of approvals for both mortgages and remortgages, with remortgages increasing more than mortgages.

Together, consumer credit and mortgage debt give us total household debt levels, which now stand at around 140 per cent of disposable incomes. Household debt reached a peak of 157 per cent of disposable incomes in 2007, before falling until around 2014 as households deleveraged in the wake of the financial crisis.

Can’t Pay, Won’t Pay

Wages and house prices have, on the other hand, stagnated. Britain has seen the longest period of wage stagnation since the 1860s. Real wages have now been falling consistently for eight consecutive months, and this year the UK is set to have the worst record on wages of any OECD country. This has, in turn, had an impact on house prices. House prices grew by just 2.6 per cent across the UK this year, down from 4.6 per cent last year, and the slowest rate of growth since 2012. Prices in London actually fell for the first time since 2004.

Falling house prices may be good for first time buyers, but they represent a reduction in household wealth. This is a concern for financial stability. If households continue to take out a lot of debt against their houses, then falling house prices combined with wage stagnation may affect their ability to repay these loans. The high rates of remortgaging this month, and the strong growth in credit card lending seem to indicate that households are making up for the squeeze in living standards by taking out more credit.

It is very important to remember that, because of our poor economic performance since the crisis — particularly on wages — UK households never had the chance to deleverage. This means that continuing growth in household debt is just adding to a problem that contributed to the financial crisis and which was never really solved.

The Debt Deflation Cycle

In fact, there is an argument to be made that it is this very trend — high levels of household indebtedness — that explain our poor economic performance.

Steve Keen, one of my favourite Minskyites, argues that there are a number of economies that are becoming ‘debt zombies’. They get saddled with higher and higher levels of private debt, and debt servicing starts to take more and more money out of the real economy, whilst increasing inequality.

Debt interest payments are, after all, just transfers of wealth from those without assets to those with assets — they do nothing to increase economic output. The wealthy who receive this money recycle less of it into the real economy than the less wealthy, instead investing it in various financial and non-financial assets. This ‘debt deflation cycle’ erodes aggregate demand and, more slowly, the productive potential of the economy more broadly.

Japan fits this pattern well — it had incredibly high levels of private debt before its financial crisis in the 1990s, and since then it has been in a persistent ‘balance sheet recession’ in which households are so leveraged that they can’t be convinced to take on more debt, even through record low interest rates. Since the financial crisis, the UK economy has started to look worryingly like Japan’s.

Quantitative easing is a way of getting around this issue by increasing demand through ‘portfolio rebalancing’. This is a euphemism for inflating asset prices, which makes the wealthy wealthier, and therefore more likely to spend money in the real economy. Except rich people don’t spend all that much money in the real economy, so the real effect is to dramatically exacerbate inequality. In the absence of any real economic growth, the massive increase in prices for certain types of assets — particularly financial assets such as equities — has created a new bubble that will eventually have to burst.

Add the business cycle into this, and you have the makings of a perfect storm. Historically, recessions of one kind or another come every 10–15 years like clockwork. At some point, household credit will have to stop growing, and the economy will start to slow down, creating a positive feedback loop that leads to a new round of debt deflation.

Dr. Doom’s Recession Forecaster

In fact, the slowdown in credit is a sure sign that a recession is coming. Keen (2017) — who was one of the only people to predict the financial crisis — has built a model of crisis-prediction based on private debt levels (a variable which is left out of mainstream economic modelling). It is when the growth in private debt begins to slow down that instability starts to accelerate. As he writes:

‘If the debt ratio starts at 200 per cent of GDP, and total expenditure in [year one] is $1.4trn — $1trn from the turnover of existing money and $400bn from credit. When the growth of credit slows [from 20 per cent to 10 per cent in year 2], total demand is $1.34trn: $1.1trn from GDP and $240bn from credit. This is $60bn less expenditure than the year beforehand — even though both GDP and debt have continued to grow…

Once an economy has a substantial level of private debt to GDP, and that ratio is growing faster than GDP, then a stabilisation of the ratio will cause a serious recession, even without any reduction in the rate of GDP growth.’

I would argue that the combination of a bubble in financial markets, high levels of household leverage, and a slowing in the rate of credit growth means we’re on track for another recession. It won’t be as big as the last one (largely because there is unlikely to be a systemic crisis relating to mortgage debt as there was in 2007), but in the context of the sluggish growth and the erosion in people’s standards of living since the crisis, it will have a very serious impact on the least well-off in our society.

It’s just a question of when.