Chill out about the debt bubble?

Not yet.

What role did high levels of household debt play in generating the crash and what do they mean for our economy over the next few years? 

Well-worn questions, you might think. And no shortage of people have asserted answers.  Following 2008, a whole new crunch-lit genre of books emerged to explore this. There is – or perhaps, was – something of a post-crash orthodoxy that the rise of easy credit, fuelled by run-away rewards for the super rich, and a squeeze elsewhere, encouraged ever greater borrowing. 

A favoured narrative, often echoed by the coalition, is that debt ballooned as consumers (and home buyers) went on an irresponsible binge – it was all demand-led.  Others argue, particularly in the US, that exploding debt reflects an act of policy – whether explicit or implicit – to increase the supply of easy credit for low and middle income groups who were seeing their wages stagnate.  From this perspective, it was less a story of families living beyond their means and more about coping when their means stopped growing. 

More recently, however, there has been a counterblast to these prevailing views.  The FT’s economics editor Chris Giles, a leading authority on our current economic predicament, maintains that fast-rising household debt should be greeted with little more than a shrug of the shoulders. Ben Broadbent of the Bank of England’s MPC makes a similar case. Higher debt is essentially about mortgages and it reflects rising house prices (let’s leave to one side for now the fact that rising debt and assets signifies a big transfer between the generations, benefiting the old at the expense of the young). And once we do take assets into account we find that the net financial position of households is roughly similar to the position twenty years ago. Relax.

Nor should we get het up about the banks having undertaken an orgy of easy and ill-judged lending. Few of the loans made to UK households have turned nasty. Banks made stupid mistakes, to be sure, but they mainly came in the form of bad loans made overseas, not in the UK (as highlighted in this good blog by Ben Chu discussing the speech by Broadbent). 

So, rather than fret about the enormous size of our debt overhang and what it means for our future growth prospects, we should move along and worry instead about something more meaningful.

This account is right, of course, to point out that not all the growth in household debt is problematic.  Plenty of households will have borrowed  more for an asset (a house) that is worth a bit more, and achieved this by taking on a debt they are capable of servicing. Nothing much wrong with that. But in scoring this point, advocates risk downplaying a bigger one: debt still matters.

First, the distribution of debt burdens across different income groups is important.  Aggregate data often conceals far more than it reveal. As the chart below shows, at the bottom of the income distribution the growth in consumption appears to have massively outstripped increases in income – unsustainably so.  (A health warning is necessary here: survey data on the lowest - and highest -  incomes can be highly imperfect, so a degree of caution is warranted on the precise numbers, but the overall pattern is likely to be correct). 

Source: NIESR analysis for the Resolution Foundation

What was driving this growth in consumption is less clear cut. Part of it is likely to be underlying shifts in the cost of living that bore down hard on low income families. Another element will have been increased mortgages (though the proportion of the poorest holding a mortgage barely rose from 1997-2007, so this isn’t likely to be the only thing going on here). And if the UK consumer is anything like their US counterpart, high levels of inequality may have played a role in generating ‘trickle-up consumption’ – whereby lower income groups strain to keep up with the spending of the affluent.  

Second, we shouldn’t be complacent about the number of bad loans or repossessions. Depending on the definition applied, between 5 per cent and 8 per cent of mortgages are  currently in forbearance – an agreement between mortgagors and their bank which usefully allows repayments to be rescheduled – but this stay of execution cannot be expected to last indefinitely or resolve the underlying affordability issues that hang over many households.

Third, the revisionist argument is in danger of downplaying the risks – potentially scary ones – of what might happen if, eventually, interest rates rise before we have strong household income growth (a point highlighted on this blog before).  True, at the moment, with the economy crawling along the floor and the euro-zone teetering on the brink, talk of higher interest rates feels very far-fetched.  But with inflation still stubbornly above target, and the Bank yet again claiming it will be another year before it falls into line (meaning inflation will have been above target for most of eight years) the medium term outlook for interest rates remains uncertain. At some point the interest rate hawks will regroup – and eventually a more normal level will return.  

All this matters greatly because a high debt burden means many households are already highly exposed; we just tend not to talk about it much because the headline Bank rate is so low. Consider the current burden of servicing mortgage payments for low to middle income households.  It is broadly similar, incredibly you might think, to the burden faced in the late 1990s when interest rates were 5 to 7 per cent. That’s partly due to the rapid growth in interest rate spreads, and partly due to the greater stock of household debt. 

An increased burden: proportion of gross income accounted for by mortgage payments among low to middle income owners

Source: Resolution Foundation 

Which takes us on to the final point: the extent to which the burden of debt will continue to bear down on UK consumers – or at least a sub-set of them. The truth is no-one really knows whether or how far household debt needs to fall. If we listen to McKinsey, we’d believe that the UK is only just beginning the painful adjustment – behind countries like the US – and it could take a decade before the ratio of UK household debt to disposable income returns to its pre-bubble path.  Other analysis  argues that to be "sustainable", household debt needs to fall from the current level of just below 150 per cent relative to income to nearer 115 per cent - a process that is likely to take until 2019 (after fiscal balance has been achieved). If so, deleveraging as well as public austerity will be a drag on consumers.  

Four years on and we’re still to have a full reckoning with the crisis. UK household debt didn’t cause it all. And high levels of debt aren’t always bad in themselves.  But we’d be silly to be sanguine.  The debt mountain makes us highly vulnerable, and will be living with it for some while yet.

In the shadow of a debt mountain. Photo: Getty Images

Gavin Kelly is chief executive of the Resolution Foundation 

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Q&A: What are tax credits and how do they work?

All you need to know about the government's plan to cut tax credits.

What are tax credits?

Tax credits are payments made regularly by the state into bank accounts to support families with children, or those who are in low-paid jobs. There are two types of tax credit: the working tax credit and the child tax credit.

What are they for?

To redistribute income to those less able to get by, or to provide for their children, on what they earn.

Are they similar to tax relief?

No. They don’t have much to do with tax. They’re more of a welfare thing. You don’t need to be a taxpayer to receive tax credits. It’s just that, unlike other benefits, they are based on the tax year and paid via the tax office.

Who is eligible?

Anyone aged over 16 (for child tax credits) and over 25 (for working tax credits) who normally lives in the UK can apply for them, depending on their income, the hours they work, whether they have a disability, and whether they pay for childcare.

What are their circumstances?

The more you earn, the less you are likely to receive. Single claimants must work at least 16 hours a week. Let’s take a full-time worker: if you work at least 30 hours a week, you are generally eligible for working tax credits if you earn less than £13,253 a year (if you’re single and don’t have children), or less than £18,023 (jointly as part of a couple without children but working at least 30 hours a week).

And for families?

A family with children and an income below about £32,200 can claim child tax credit. It used to be that the more children you have, the more you are eligible to receive – but George Osborne in his most recent Budget has limited child tax credit to two children.

How much money do you receive?

Again, this depends on your circumstances. The basic payment for a single claimant, or a joint claim by a couple, of working tax credits is £1,940 for the tax year. You can then receive extra, depending on your circumstances. For example, single parents can receive up to an additional £2,010, on top of the basic £1,940 payment; people who work more than 30 hours a week can receive up to an extra £810; and disabled workers up to £2,970. The average award of tax credit is £6,340 per year. Child tax credit claimants get £545 per year as a flat payment, plus £2,780 per child.

How many people claim tax credits?

About 4.5m people – the vast majority of these people (around 4m) have children.

How much does it cost the taxpayer?

The estimation is that they will cost the government £30bn in April 2015/16. That’s around 14 per cent of the £220bn welfare budget, which the Tories have pledged to cut by £12bn.

Who introduced this system?

New Labour. Gordon Brown, when he was Chancellor, developed tax credits in his first term. The system as we know it was established in April 2003.

Why did they do this?

To lift working people out of poverty, and to remove the disincentives to work believed to have been inculcated by welfare. The tax credit system made it more attractive for people depending on benefits to work, and gave those in low-paid jobs a helping hand.

Did it work?

Yes. Tax credits’ biggest achievement was lifting a record number of children out of poverty since the war. The proportion of children living below the poverty line fell from 35 per cent in 1998/9 to 19 per cent in 2012/13.

So what’s the problem?

Well, it’s a bit of a weird system in that it lets companies pay wages that are too low to live on without the state supplementing them. Many also criticise tax credits for allowing the minimum wage – also brought in by New Labour – to stagnate (ie. not keep up with the rate of inflation). David Cameron has called the system of taxing low earners and then handing them some money back via tax credits a “ridiculous merry-go-round”.

Then it’s a good thing to scrap them?

It would be fine if all those low earners and families struggling to get by would be given support in place of tax credits – a living wage, for example.

And that’s why the Tories are introducing a living wage...

That’s what they call it. But it’s not. The Chancellor announced in his most recent Budget a new minimum wage of £7.20 an hour for over-25s, rising to £9 by 2020. He called this the “national living wage” – it’s not, because the current living wage (which is calculated by the Living Wage Foundation, and currently non-compulsory) is already £9.15 in London and £7.85 in the rest of the country.

Will people be better off?

No. Quite the reverse. The IFS has said this slightly higher national minimum wage will not compensate working families who will be subjected to tax credit cuts; it is arithmetically impossible. The IFS director, Paul Johnson, commented: “Unequivocally, tax credit recipients in work will be made worse off by the measures in the Budget on average.” It has been calculated that 3.2m low-paid workers will have their pay packets cut by an average of £1,350 a year.

Could the government change its policy to avoid this?

The Prime Minister and his frontbenchers have been pretty stubborn about pushing on with the plan. In spite of criticism from all angles – the IFS, campaigners, Labour, The Sun – Cameron has ruled out a review of the policy in the Autumn Statement, which is on 25 November. But there is an alternative. The chair of parliament’s Work & Pensions Select Committee and Labour MP Frank Field has proposed what he calls a “cost neutral” tweak to the tax credit cuts.

How would this alternative work?

Currently, if your income is less than £6,420, you will receive the maximum amount of tax credits. That threshold is called the gross income threshold. Field wants to introduce a second gross income threshold of £13,100 (what you earn if you work 35 hours a week on minimum wage). Those earning a salary between those two thresholds would have their tax credits reduced at a slower rate on whatever they earn above £6,420 up to £13,100. The percentage of what you earn above the basic threshold that is deducted from your tax credits is called the taper rate, and it is currently at 41 per cent. In contrast to this plan, the Tories want to halve the income threshold to £3,850 a year and increase the taper rate to 48 per cent once you hit that threshold, which basically means you lose more tax credits, faster, the more you earn.

When will the tax credit cuts come in?

They will be imposed from April next year, barring a u-turn.

Anoosh Chakelian is deputy web editor at the New Statesman.