In a recent contribution, Arestis and Sawyer (2015) argued that the increase in the UK household sector debt helped the recovery of GDP growth. Household debt increases substantially when households experience stagnating incomes (due to rising prices and falling wages) and borrow in order to finance their consumption expenditures, which in the UK amounts to two thirds of demand. The Bank of England (2016) suggests, “An uncertain macroeconomic environment raises the prospect that households could face challenges to their ability to service their debts.” The increase in the UK household debt has continued since then, and indeed has become even more worrying in view of the possible “normalisation” of interest rates and the monetary dimension in more general terms by the Bank of England; this possible emergence could have serious implications for the households in view of their high debt in relation to economic activity.[1]
Interestingly enough, these developments, in terms of UK household debt, have worried the UK monetary authorities, which have initiated policy measures to avoid serious problems resulting from indebtedness. Indeed, the Bank of England (2016) in its Financial Stability Report suggested, “Highly indebted households are particularly vulnerable to shocks, such as falls in incomes or increases in interest rates, which threaten their ability to service their debts. If these households cut consumption sharply in order to service their debts, this may amplify any downturn in economic activity. Alternatively, if households default on their debts, this can test the resilience of lenders directly.” It is also stated, in the same report, “Total lending to households grew by 4.1% in the twelve months to September 2016, close to the fastest growth rate since the global financial crisis.” As a result of these and other risks in the UK banking sector, the Bank of England believes that tackling these problems is best through financial regulation and macro-prudential policies. The Bank of England’s Financial Policy Committee (FPC)[2] decided at its May 25, 2016, meeting to increase the UK countercyclical capital buffer rate (or systemic risk buffers), which would ensure that banks could provide lending and other needed banking services in times of financial stress.
The Governor of the Bank of England, though, announced on July 5, 2016 (at the launch of the Bank of England’s financial stability report) that the countercyclical capital buffer imposed on the UK commercial banks would be relaxed by the FPC (from 0.5% to 0% until at least June 2017). This was to boost lending to business and households (estimated to be £150bn), which became necessary, in the FPC’s opinion, in view of the financial stability risks as a result of the UK vote to exit the EU. However, and in view of mounting consumer credit (car loans, personal loans and credit card debt), which increased 10.3% in the 12 months to May 2017, and with the household debt closely to 140% of income, the Bank of England imposed on June 27, 2017, the “counter-cyclical capital buffer” from zero to 0.5 percent of the lenders’ risk-weighted assets. The buffer would rise by a further 0.5 percent in November 2017. Banks will have a full year from then to raise the £11.4 billion as needed. The countercyclical buffer is a way of forcing banks to set aside capital in good times in order to keep lending steady to the wider economy, even during an economic downturn. The buffer can be “turned off” in bad times. The Bank of England also increased the minimum requirement on the leverage ratio, a bank’s capital to its total assets, from 3% to 3.5%. Lenders do not have to include central bank reserves in their total balance sheets when accounting for the leverage ratio. In addition, and on the June 27, 2017, the Bank of England’s FPC “clarified” that in terms of mortgages, lenders should carry out affordability checks for new borrowers, if interest rates were increased by three percentage points.
If difficulties arise with households in terms of their repayments, two problems may emerge: households may reduce their spending to be able to keep up with debt repayments; or households may default on their loans, thereby putting banks at risk. There is also a further risk in that additional squeeze on households may emerge in that they are already in some difficulty in view of wages fail to keep pace with inflation; this of course hurts consumption, which is a key driver of economic activity. Borrowing has helped to fill the gap.
High household debt, in the case of the UK and of course in other countries as well, implies a serious problem. When interest rates, which currently are extremely low, not just in the UK but also around the world, are normalised, as is expected to take place soon, serious problems may very well arise; even modest increases in the rate of interest would be a problem for both companies (financial and other) and households.[3] Economic activity would thereby be derailed.
Notes
[1] A similar example was the US experience prior to the global financial crisis of 2007/2008, when the enormous increase of household debt enhanced the level of economic activity, but contributed to the global financial crisis when interest rates increased (see, for example, Arestis, 2016).
[2] The Financial Policy Committee is an official committee of the Bank of England. It is a new body, which was introduced after the global financial crisis of 2007/2008 and the subsequent great recession. It is responsible for monitoring the economy of the United Kingdom. It focuses on the macro-economic and financial issues that may threaten long-term growth prospects. There is also the Prudential Regulation Authority, which is focused on micro-prudential issues and policies.
[3] The Monetary Policy Committee of the Bank of England voted at its meeting of the 3rd of August, 2017, to keep the rate of interest at 0.25%. However, the committee predicted two interest rate hikes over the next three years, one more than what had been estimated previously.
Sources
Arestis, P. (2016), “Main and Contributory Causes of the Recent Financial Crisis and Economic Policy Implications”, in P. Arestis and M. Sawyer (eds.), Emerging Economies During and After the Great Recession, Annual Edition of International Papers in Political Economy, Houndmills, Basingstoke: Palgrave Macmillan.
Arestis, P. and Sawyer, M. (2015), “Austerity Cannot Explain the Current UK Economic Growth”, Challenge, 58(2), pp. 149-159.
Bank of England (2016), Financial Stability Report, Issue No. 40.
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