How stable is the economic recovery?

In my last article I wrote about how the performance of the UK economy in the hands of Osborne and Cameron has been poor, despite the signs of a recovery in 2014. In this piece I will be continuing my bashing of the Bullingdon boys by claiming the growth we have seen in the past year may not be conducive to a long-term stable recovery, despite the insistence that their “long term economic plan” is working.

My concern with the higher growth we have had since the beginning of 2014 is it has been driven by increased consumption rather than investment.

Is this really something we should be worried about? Maybe not in itself, but the reason for the growth in consumption should cause some alarm, as it appears to be an increase in household debt. As you can see from the graph below, which shows unsecured lending, households have returned to pre crisis levels of lending with borrowing increasing to £1.2 billion a month. This increase in household debt worries me for two reasons. Firstly as it may not be sustainable and therefore the consumption will decrease when the households try to pay off the debt, and the second is that this large increase in household debt is symptomatic of an economy that is not working for the average family.

Let’s begin with my first concern. In 2008 when the housing bubble burst and house prices plunged, the families who had accumulated large debts in the preceding boom where left in serious trouble, with some having mortgages worth more than their house (negative equity). Not only did the end of the housing bubble mark the beginning of the recession, the huge amount of household debt in the UK may have been responsible for increasing the depth of the recession. This is as at the onset of the downturn households with large debts tried to pay off as much of those debts as possible due to the uncertainty about their future earnings. People lend on the assumption that they will make enough in the future to pay their debts off, so when they are no longer confident they will earn enough to do so they become uncomfortable with the debts hanging over them. So households scrambling to pay off their debt further reduced demand, lengthening the downturn. This view follows from a 2014 Bank of England paper that found “highly indebted UK households made larger-than-average cuts in spending, relative to income, after 2007”.

So what are the implications for our current situation?

Well if households continue to lend, and consequently continue to spend, then we may be ok and given enough time investment may start to increase (although Japan has had low investment for almost two decades so there is no guarantee). But the problem comes when people can no longer, or no longer feel they should, borrow more. When interest rates rise, which they inevitably must, people will be under strain to pay back old debts meaning they will be unable to lend more. In the words of the German economist Rudi Dornbusch “It is hard for a man to establish a relationship with a lender if the estranged wife keeps barging in claiming alimony”. With households paying more back to lenders than they are receiving, spending will drop and the Tories consumption led recovery will start to slow down.

What about my second worry then, that the increase in household debt reflects how the economy is not working for normal people. I say this as I am convinced by the argument that the rise in household debt, which has been a feature of many advanced economies over the past few decades, is due to the stagnation in wages. With families not seeing substantial increases in their earnings they have used debt as a substitute in order to raise their living standards, however as we seen in 2008 continually using debt to finance spending is not sustainable.

It has been suggested by the OECD recently that the UK could resolve this problem by raising worker productivity. This is as in standard economic thinking a rise in productivity leads to a rise in wages, which in the UK will mean less reliance on debt for consumption. However the problem with this view is that productivity growth and wage growth do not seem to be as intertwined in reality as they are in a standard textbook. Since the 70s productivity has grown by 114% yet wages have only increased 72%, and the divergence between the two is even larger in other countries like the US. So finding a way to raise peoples wages may be harder than an economist would first think, meaning the British household’s reliance on debt will continue for some time to come.

The UK’s overdue recovery in terms of growth has taken a weight off the exchequers shoulders, just as the word ‘depression’ was starting to seem an appropriate term for the performance of the British economy. However the recovery’s reliance on debt is a cause for concern and there is a hint of irony to the fact that the Conservative’s “long term economic plan” is centred on fighting the spectre of debt, and yet now they are claiming their plan is working due to a debt-fuelled consumption increase. Although I do not want to contribute too much to the anti-debt fetishism that has become part of our collective consciousness, high levels of household debt have caused serious problems before and we should also be asking, why are the British people so reliant on debt to fund an acceptable standard of living?

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This post was written by Joe Walters