Aversion to debt could slow us down

YESTERDAY the mood of the markets shifted against the idea of an early rise in British interest rates. This may shift again if, as expected, the Federal Reserve increases US rates later this week, but in any case the events of the last few days must have made it clear that by the end of the year interest rates will be heading up.

But if that is now generally accepted, its consequences have attracted less attention: in particular the effect on willingness to borrow by consumers and homebuyers.

The rise in household debt during the 1980s was an international phenomenon, but the trend was most apparent in the UK. By the end of the 1980s, British households had higher debt in relation to income than any other large industrial country: in 1989 it was 105 per cent of disposable income, against 87 per cent in West Germany and Canada, 92 per cent in Japan, and 96 per cent in the US.

Since then households everywhere have been gradually pulling back their debts, and Britain was no exception. But some commentators have argued that the fall in the savings ratio over the last 18 months and, in particular, the sharp rise in consumer borrowing in June (at pounds 685m the highest net monthly rise ever recorded) suggested that we were going back to our 1980s borrowing habits. If that were so, growth next year would continue to clip along at a rapid pace, perhaps more than 3 per cent, and the outlook for both inflation and interest rates would be correspondingly higher.

Not so, says Kleinwort Benson in its latest economic note, which argues that consumption next year will be much weaker, largely because of consumers' aversion to debt. The rise in consumer credit in June was, it argues, more a function of slower debt repayment than a surge in new borrowing and, in any case, the figures are based on a narrow definition of consumer borrowing.

If one looks at the main way in which individuals borrow - to buy homes - there is a rather different picture. Property transactions remain at the levels of the late 1970s rather than the late 1980s.

The Kleinwort economic team makes a number of further points, all of which it believes suggest a slowing of growth next year.

First, money supply, on what it has long been argued is the most useful way of calculating it, the Divisia measure, fell in the second quarter of the year, the first fall on record. This is a result of a fall in the retail deposits of people and companies, which more than offsets a rise in money supply on other measures. While still sceptical of the usefulness of Divisia, the Bank of England has accepted the case for it in that it now publishes money supply calculated in this way. If Divisia really does give a good guide to future spending intentions, this fall is extremely important for it suggests that there may well be a pause in consumption, and GDP growth, soon.

Consumption is certainly the key to the pace of recovery: both exports and investment will be fine, but consumption accounts for such a large proportion of GDP that, if it falters, growth is bound to be affected.

Kleinwort also points out that, after initially rising in the early stages of the recovery, the figures now show employment falling again. While the savings ratio may fall a little further, from its present 10-11 per cent range to about 8 per cent, this is normal at this stage of a recovery, it says. It also points to the squeeze on real incomes, which are now rising at an annual rate of only a little over 1 per cent, against 3 per cent early last year.

A debt-averse recovery would naturally be slower than a geared- up one. So far, the pace of recovery has outstripped virtually all the economic forecasts. Kleinwort thinks all will change. It points out that, where 18 months ago it was more optimistic about growth this year than the consensus (and has been proved right), it is now much more pessimistic for growth next year, suggesting this will turn out to be only 1.9 per cent.

Perhaps the easiest way for the rest of us to get an idea of whether this pessimistic outlook is on the right lines will be to look at house prices. These are tremendously sensitive to interest rates and to interest-rate expectations. The Nationwide and Halifax surveys of prices are not ideal, but they are not bad indicators of what is happening if one smooths out the individual monthly reports. If they both show prices picking up in the autumn, showing year-on-year rises of, say, 5 per cent, then that would suggest sufficient consumer confidence will be maintained through the spring to keep growth at 2.5 per cent or more.

If, on the other hand, house prices are flat though the winter, then do not be surprised if growth next year has a one as the big number, not a two.