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Debt doubts

Debt doubts

It's important to know what Charlie Munger calls the edge of our competency: we must be aware of what we don't know. This is true when considering consumer debt.

If next week's numbers from the Bank of England corroborate last month's, they'll show a slowdown in consumer credit growth: last month, this growth fell to a 17-month low. With retail sales having fallen by 2.7 per cent in the last three months, this might suggest that excessive household debt has finally begun to constrain growth.

Such a view, however, is questionable.

One problem is that we just don't know what is the right level of debt. One reason for this is simply that this level depends upon future income growth, which we cannot know. In fact, basic textbook economics says households cannot have excessive debt because they optimise their borrowing. Although this sounds implausible, it's hard to say just how wrong it is: it's possible that while some people have borrowed too much, others are irrationally or wrongly pessimistic and have borrowed too little.

At the end of last year, consumer debt (which excludes mortgages and student loans, but includes things like car loans and credit cards) stood at £192.9bn. That's £7,225 per household. Is this too much? You won't get much of a car for this. And it is equivalent to a repayment of £200 per month over three years - which is less than 10 per cent of the typical household's income after tax.

The raw numbers, then, don't tell us much.

Nor does standard macroeconomics with its fiction of a representative consumer. Whether debt matters or not depends upon differences between households.

Think of people as lying on a spectrum. At one end are those with no debts and lots of liquid assets. At the other extreme are people who are desperately struggling to pay interest. Now think of another spectrum, that of this year's surprises. At one end, some will get a nice surprise: a big promotion or bonus or a nice legacy. At the other, some will lose their jobs and not quickly get another that pays so well: even in today's stable times, almost 3 per cent of people move out of work every quarter.

The question is: how does the latter spectrum map onto the former? If the highly-indebted strugglers enjoy the nice surprises they could repay debt and maintain their spending while those who suffer bad news can run down cash to do so, at least for a while. But if on the other hand, the strugglers get the bad news then we'll see distress, defaults and falling spending.

It's not the shocks that matter so much as the distribution of them. And we can't know how these will fall.

There is, though, one thing we do know: that it's rare for consumers in aggregate to cut debt a lot. Yes, consumer debt fell by a quarter between 2008 and 2012, But that was not, for the most part, because households realised they'd irrationally taken on too much debt. It was instead because banks refused to lend and because the banking crisis caused people to cut their expectations for future income growth. Recessions are caused more often by those in power than by consumers.

In fact, it's possible that the fall in retail sales has nothing to do with high debt. It might instead be because inflation has (perhaps temporarily) squeezed real wages, and because spending surged in the autumn as shoppers pulled forward their spending to beat the price rises they knew sterling's fall would cause.

There are, of course, risks to the economy. But we can't be at all confident that high consumer debt is among them.

MORE FROM CHRIS DILLOW...

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Chris blogs at http://stumblingandmumbling.typepad.com

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By Chris Dillow,
23 February 2017

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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