Early last year, McKinsey Global released research showing that the UK economy had the third highest debt in the developed world, behind Ireland and Japan (see next chart).
McKinsey’s analysis followed an earlier Strategy Note by Tullett Prebon, which argued that the British economy had become critically dependent on private borrowing and public spending. And with both drivers practically disappearing, the UK economy faced a prolonged period of economic stagnation:
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The problems facing the UK today are the direct result of reckless consumption by individuals and government alike, the former funded by equally reckless lenders. Now, and although the public are not yet aware of it, the bill for this era of unheeding greed has turned up. To put it colloquially, many of the imported gadgets might already be in landfill, but the debt incurred to buy them remains.
If Britain’s economy has indeed become dependent upon annual debt increments exceeding 10% of GDP, why was there not at least some improvement in growth rates? The conundrum is one that asset managers term returns on capital employed – Great Britain plc has increased its capital (debt) base very markedly without generating any improvement at all in income growth. Why?
To understand the conundrum posed by a growing capital (debt) base and diminishing growth, we need to distinguish between two types of debt. These are termed ‘self-liquidating’ and ‘non-selfliquidating’ debt.
If the owner of a successful restaurant borrows to invest in additional seating space, the debt is selfliquidating because it will be serviced and paid off from the higher income that the expanded restaurant will generate. But borrowing to pay for a new car or a foreign holiday is non-selfliquidating, because it is a form of consumption which does not leverage the borrower’s income. Though the parallels are necessarily less than exact, the sharp fall in Britain’s return on capital reflects the fact that the overwhelming bulk of new borrowings have been non-self-liquidating…
Government has been guilty of over-consumption, and very little has been invested in self-liquidating projects such the improvement of the country’s road, rail, power or telecommunications infrastructure.
But the biggest problems have not been caused by government, but by individual borrowers.
The biggest single debt increment during the period between 2002 and 2009 was mortgage borrowing, which increased by £590bn between those years. Many borrowers saw this as investment, a view which was profoundly mistaken even though many policymakers and even bankers managed to delude themselves otherwise. As average property prices soared from £121,000 in 2002 to £197,000 in 2007 (a real terms increase of almost 70%), escalating mortgage debt looked like an investment, and a good one at that.
But to believe this was to overlook two critical points.
The first point that was generally misunderstood was that property prices, whilst realisable on an individual basis, are not realisable in the aggregate. Therefore, and as borrowers and lenders alike were to discover, property prices, far from being an absolute, are an example of ‘notional value’.
The second reason why the escalation in mortgages was not an investment was that a steadily diminishing proportion of new issuance was actually going into the purchase of homes – by 2007, only 35% was being used for this purpose, with the balance going into buy-to-let (BTL) (26%) and equity release (39%). Whilst BTL might have looked like an investment, the reality was that it was a low- or negative-return punt on property prices continuing to rise ad infinitum. Equity release, meanwhile, amounted to the direct leveraging of balance sheets into consumption.
That the property market could not go on rising indefinitely was demonstrated in dramatic fashion when average prices fell by 19% between 2007 (£197,000) and 2008 (£160,000). Despite this correction, property prices still look very exposed in terms of earnings multiples, which remain far above historic norms…
The harsh reality is that the overwhelming bulk of private borrowing during the Brown era was channelled into immediate consumption. ‘Spending like there was no tomorrow’ showed how the public had bought into the ‘easy money’ mentality of the ‘Brown bubble’, but individuals can hardly be criticised for this, since government itself had done precisely the same thing, increasing public spending by more than 50%, in real terms, between 1999-2000 and 2009-10…
The Strategy Note then went on to provide a bleak outlook for the UK economy. In a nutshell, private credit had turned negative and was likely to remain subdued for an extended period. Home prices were still way overvalued, eliminating the prospect of a significant pick-up in mortgage borrowing. And with the Government committed to all but eliminating the budget deficit by 2015-16, the Government would be unable to fill the void in the economy left by the reduction in private sector credit.
Past dependence on substantial levels of annual incremental borrowing has put Britain into a high-debt, low-growth trap. Because growth was feeble even when fuelled by the continuous injection of debt-funded demand, the outlook, now that the country’s borrowing capacity has been maxed out, may be for extremely low economic growth. The collapse in private borrowing has dreadful implications for two of Britain’s eight biggest industries (real estate and construction) and may have adverse implications for a third (financial services).
Another three big sectors (health, education and public administration and defence) are necessarily ex-growth now that the expansion of public spending is over. Together, these six sectors account for 58% of the economy, which makes the delivery of aggregate growth very difficult, and perhaps impossible.
The UK is already showing unmistakeable signs of economic deterioration. Real incomes are declining, a trend to which individuals are leveraged by the high and increasing cost of such nondiscretionaries as food, fuel and utility bills. To make matters worse, interest rate rises seem inevitable, either for policy (inflation) reasons or because of bond market jitters. If the outlook is indeed for low growth, the government’s growth-dependant deficit reduction plan won’t work. And, if the plan were to come unstitched, sterling would come under severe pressure, exacerbating inflationary pressures and compounding the misgivings of international investors holding British debt.
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Although published in mid-2011, Tullett Prebon’s analysis is looking ever more prescient. The release last week of the UK Budget showed that economy is facing a Japanese-style ‘lost decade’, with the recovery since the onset of the Global Financial Crisis (GFC) even worse than the Great Depression:
With the UK economy facing anaemic growth, and Government finances already over extended, the Government is now endeavouring to ‘kick the can down the road’ by encouraging home buyers to leverage-up into housing via £130 billion of off-balance sheet government mortgage guarantees – akin to overcoming a hangover by drinking more alcohol. But as noted by Tullett Prebon above, it was the UK’s leveraging-up into housing between 2002 and 2009 that helped get it into this mess in the first place. Therefore, doubling down on housing now risks a much bigger debt hangover down the track.
The UK experience provides a salutary lesson for Australia should the government, once again, seek to pump housing demand via another first home buyers boost. While our government finances are currently in a much stronger position than the UK’s, our household debt levels are higher. Also, government finances could worsen considerably in the event that Australia experiences a disorderly unwinding of the mining boom, including sharply falling commodity prices and a steep drop-off in mining-related capital investment.
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness.
Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.
