Credit boom may end in bust for UK housing market

As Britons labour under borrowings of £880bn, economists fear a reckoning awaits

Would the monetary policy committee have cut interest rates last month if its members had known the Bank of England was about to publish figures showing consumer debt had hit an all-time high?

We will never get an answer to that hypothetical question, although the MPC will pass judgement when it sets rates on Thursday. Most City analysts believe it will keep rates unchanged, in part because of evidence that households are spending and borrowing like there is no tomorrow.

As Benjamin Franklin, the American economist and inventor, said: "Tomorrow every fault is to be amended - but tomorrow never comes."

Except that now several commentators believe households will finally be forced to face up to the harsh reality that they are simply carrying too much debt.

The main fear is that they will suddenly, and collectively, realise the current low interest rate environment means their debt will not be whittled away by inflation and so drastically cut their spending.

Analysts fear this new dawn will bring misery, sending house prices crashing and leaving millions with mortgages worth more than the value of their homes. This could in turn trigger a financial crisis as high street banks find themselves saddled with failed loans.

This nightmare scenario - dubbed negative equity by economists - is worrying analysts in the light of recent figures. Total borrowing rose almost £10bn in June, the largest increase since the Bank of England began monthly records a decade ago.

It means Britons are labouring under an £880bn debt mountain - equivalent to £15,000 for every man, woman and child in the country.

And all that was before any impact from the latest rate cut, which pushed the level of interest rates to their lowest for almost 50 years.

Michael Saunders, a European economist at Citigroup, says: "It is very rare to find a case where a credit boom has been deflated gently."

Others, such as the consultancy Capital Economics, go further. It forecasts consumer spending will fall next year for the first time since 1991 when the UK was mired in recession. Its forecast is closely connected to its prediction that house prices will fall sharply over the next three years as rising unemployment and growing unaffordability pull the rug under the market.

If it is right that house prices will fall 20 per cent from their peak, net wealth - wealth minus debt - will slump by 13 per cent.

But according to Vicky Redwood, an economist at the consultancy: "House prices do not even have to fall to cause a significant readjustment. All it takes is for house prices to rise by less than people were expecting for households to reassess how sensible they were to take on so much debt."

She warned it was wrong to assume that because the current low levels of loan costs made debt affordable, there was no need to worry about the huge volumes of debt being taken on. "Anything from a rise in unemployment to a realisation that debt is not being eroded away in real terms like it was in the past could cause households to take fright at the sheer level of debt they have built up," she said.

If this comes to pass, the Bank under its new leader, Mervyn King, will face a challenge. The Bank has played a key role in stoking up consumer demand by cutting rates in the face of a global slowdown.

"The basic reason [for the debt mountain] is that monetary policy is very loose," says Citigroup's Mr Saunders.

"The scale of the credit boom is evidence that the scale of the stimulus is more than the Bank expected. They have got more bang for their buck."

He said with new evidence daily of a pick up in the US, the Bank must abandon any thought of rate cuts. "It's hard to argue they should hike but as the external side improves they should at least start talking about hiking," he says. "And when they do hike, they should hike early."

He doubts this will have a huge impact in deflating the credit boom. Even if rates rose from 3.5 per cent to 3.75 or 4 per cent, they would still be close to 50-year lows and would do little to panic people into examining their debt position, he said.

He says the wider issue is how the Bank goes about its job of targeting inflation. "Starting from scratch, low inflation is a good thing because it leads to better allocation of resources," he says.

During a house price boom, resources pour into areas such as construction, property companies and estate agencies and away from, for example, manufacturing.

"There is an argument that just aiming for an inflation target is not sufficient for central banks given that asset price booms are more destabilising for an economy over a longer period of time than a two-year horizon," he says.

There is a lively debate within the economics community. Claudio Bario, a senior economist at the Bank for International Settlements, recently suggested banks should take more account of financial imbalances such as asset price bubbles.

"Monetary policy rules that do not take these imbalances into account may unwittingly accommodate their further build up," he said.

He cited research showing a 1 percentage point rise in the rate of growth of domestic credit increased the chance of a banking crisis in the following year by 0.06 per cent. Credit growth is currently running at 14 per cent.

Colin Warren, at independent analysts GFC Economics, said the current situation highlighted the "inadequacies" of a narrow inflation target.

"At a time when central banks are increasingly shifting their focus away from monetary and credit aggregates, such information is as valuable as ever - not as a harbinger of inflation but rather as an early warning of an asset bubble, the bursting of which could ultimately have deflationary consequences."

The Bank of England responds robustly to the implied criticism that it is failing to target inflation with sufficient accuracy. Charlie Bean, its chief economist, insists the Bank already takes asset prices into account when it targets inflation. In a recent speech looking at the UK consumer boom Mr Bean, who voted for both rate cuts this year, said it was hard to identify an asset price bubble in the first place.

He identifies a range of factors explaining house prices including low interest rates, competition between lenders, rising numbers of households and a shortage of new homes being built.

In addition he published research showing that the households with the highest stock of debt also had the highest wealth, providing a cushion against any crash. "Whether the movement in house prices is justified by fundamentals or not is clearly central to assessing whether there is any danger posed by the build-up of household debt," he said.

He also countered the claim that a fall in house prices would trigger a correspondingly sharp fall in household spending.

"Net household wealth would fall, but rational consumers would spread the required adjustment over the rest of their lives," he said. "[They] would not need to cut back their spending sharply unless the lender were to foreclose on them for some reason."

One such reason could be a surge in unemployment but, according to Robert Barrie, UK economist at CSFB, there is little imminent danger of that.

"The single most important factor is income and the fact is that we had a two or three-year period when incomes were incredibly strong," he says.

He said it was a mistake to think that house prices drove consumer spending. "Income growth and consumer spending have moderated so the housing market has moderated. I think that's all you need to know."

He said those who focused on debt liabilities often forgot to mention the fact households had also bought piles of assets.

In the meantime British households will continue to follow the advice of the playwright John Dryden: "Tomorrow do thy worst, I have lived today."