Household finances have deteriorated. The Office for National Statistics (ONS) is expected to say next week that households were net borrowers last year, for the first time since their current records began in 1987. This is because households’ savings have fallen below their net spending on housebuying.
This does not necessarily mean that consumers have been irrational or reckless. Aggregate data tell us absolutely nothing about whether this is the case or not. What matters is the distribution of debt: if it has been taken on by those whose incomes will increase, then it’s rational and sustainable. If on the other hand it’s been taken by those who will not be able to repay, then it’s not. As Toby Nangle at Columbia Threadneedle Investments says, debt is “largely a distributional issue”.
Even if all the borrowing has been undertaken by rational people, however, we still have two problems.
In theory, rational households borrow to smooth out their spending when faced with temporary hits to their incomes. It’s likely that we did indeed have one such hit last year: a one-off rise in prices caused by sterling’s fall in 2016 led to a temporary fall in real wages.
But interest and principal still has to be repaid. This means that borrowing last year will reduce disposable incomes, and hence spending, in future. Consumption-smoothing works both ways: it stops spending falling, but also stops it rising much.
There are signs that this is already happening. The Bank of England says that consumer credit growth is slowing down, although it remains high. And the Confederation of British Industry (CBI) is likely to report next week that retail sales growth has been slow so far this year – this is consistent with the swathe of profit warnings and store closures we’ve seen in the sector.
A second problem is that repaying debt is like trying to get out quickly from a cinema; if everybody tries to do it, there’s a crush and hardly anybody succeeds. There’s a collective action problem known as the paradox of thrift: if lots of people try to reduce their borrowing, spending falls with the result that incomes fall, which in turn makes it harder (and undesirable) to reduce borrowing.
This problem is especially severe because, of course, it’s not just households that might try to reduce borrowing. The government is also trying: the Office for Budget Responsibility (OBR) last week predicted that cyclically-adjusted net borrowing would fall by 1 per cent of GDP over the next three years. This will continue to squeeze households’ incomes – not least because it entails what the UK think tank Resolution Foundation calls “significant cuts to working-age benefits”.
This in turn will prevent a rapid reduction in households’ net borrowing. In fact – barring an unexpected boom in company spending – the government can reduce its borrowing only if households don’t. The OBR’s forecast that government borrowing will fall in coming years is predicated upon a belief that households will remain net borrowers for most of the next four years.
With household debt remaining high, the Bank of England will be reluctant to raise interest rates quickly for fear of forcing a severe retrenchment by overstretched consumers. And this means continued low incomes for savers. Prudence might be a virtue, but it is not a profitable one.
