Will squeezed households really borrow more to prop up living standards?

Office for Budget Responsibility is challenged over the question of personal debt.

What are we to make of different views on the extent to which growing household debt will offset the squeeze in living standards in the coming years?

The independent Office for Budget Responsibility caused a bit of a stir at the time of the Budget when it suggested that household debt is set to rise over the rest of the parliament – from £1.6trn in 2011 to £2.1trn in 2015, or from 160 per cent of household disposable income to 175 per cent. Rising debt will sit alongside low savings, so the ratio of household saving to disposable income will fall to roughly 3.5 per cent – half its average over the past 50 years – for the duration of the OBR's forecast period.

The clash between these projections and the government's favoured narrative concerning the need for the country to rein in its debt-fuelled spending habits – public and private – attracted some attention and prompted an online debate about whether tighter fiscal policy is shifting the balance between public and private debt.

However, the underlying economic implications, and their impact on household living standards between now and the next election, remain largely unprobed. Last week the OBR published a little-noticed note that set out to clarify why it has changed its projections for household debt since last June. It makes for interesting reading – but doesn't really answer the most fundamental questions.

The most important argument that the OBR makes is that – regardless of high existing levels of debt – household indebtedness will continue to rise over the next four years as families battle to sustain their living standard, running down savings and ratcheting up more borrowing. And it is worth noting that the OBR explicitly says that its projection for household debt is premised on steadily easing credit conditions and a stronger housing market.

The savings ratio

The critical question is whether the OBR is right about how households will react: is a further rise in personal indebtedness, already at historically unprecedented levels, a realistic account of how households at the sharp end of the living standards squeeze will behave over the medium term in the post-crunch economy?

No one really knows. We can't. Never in modern times have we seen the combination of such a large fall in household incomes, the severity of the shock to the credit system, and plummeting consumer confidence. So it is very hard to know what the OBR bases its behavioural assumptions on when it claims that greater debt will prevent falling disposable incomes feeding through into reduced expenditures.

It's a view that seems to run counter to a range of recent expert opinions and forecasts. For example, the Council of Mortgage Lenders has referred to the OBR projection on the scale of the increase in household debt this year as "wildly optimistic" and at odds with its own forecasts, while PwC has projected household debt to be falling as a proportion of GDP throughout this parliament.

Roger Bootle of Deloitte has just marked down consumer spending growth in 2011 to -1 per cent, and takes issue with the notion that household savings will fall further in the medium term, saying that tight credit conditions and the current weakness of consumer sentiment will "surely mean that households will want to save more, rather than less". Likewise, the NIESR, in its most recent quarterly update, predicts that following a short-term reduction this year, the savings ratio will rise steadily until 2015.

Analysts in the US are similarly sceptical about the scope for medium-term falls in their savings ratio: Cardiff Garcia has argued in the Financial Times that, while such a position might boost the economy in the short term, "nobody would think it healthy" for the savings rate to return to the "absurd" levels of the mid-Noughties.

Room for manoeuvre?

So much for the forecasters and pundits; what does the public say? Despite a well-documented shift from borrowing to saving since the start of the credit crunch, UK households remain severely debt-stressed. Bank of England polling data shows that, at the end of 2010, half of all households said they were concerned by their level of debt.

Borrowing more remains off limits for many: one-third reported suffering some form of credit constraint. At the same time, one in three households reported savings of under £500 – leaving little scope for protecting living standards by dipping into these funds.

Our own analysis at the Resolution Foundation shows that those on low to middle incomes face sharper constraints than better-off households. As the chart below shows, while around one-third (31 per cent) of households in the top half of the income distribution said they were finding it harder to borrow to finance spending in 2010 than in 2009, this rose among those on low to middle incomes to over half (53 per cent), up from just 16 per cent in 2007.

And these are exactly the people who are going to feel the fall in living standards most acutely and who, presumably, the OBR expects to borrow more. Looking to the future, one-fifth of all households said they were saving more in anticipation of fiscal tightening. Just 3 per cent were planning on spending more.

Taken together, these findings provide powerful grounds for asking what would happen if the OBR used different assumptions about how households may run down, as well as build up, debt during the prolonged fall in living standards. Without this, existing projections appear to be a bit of a punt.

No doubt setting out different scenarios for debt in this way would expose some uncomfortable findings: growth is bound to be weaker if household expenditure tracks falling disposable income more tightly than the OBR currently expects. Projections for net exports and business investment can't just be pumped up to take up the slack. But that isn't a reason to avoid the issue.

Despite all the frothy rhetoric about "rebalancing of the economy", the growth of household consumption will be absolutely pivotal in the resumption of steady growth. Indeed, the key factor determining the strength of the UK recovery will be the uncertain reactions of millions of households, which are already close to the edge, to further falls in disposable income. The question of whether ever more personal debt can be used to fill the growing gap in living standards deserves far more serious scrutiny than it has received to date.

Gavin Kelly is chief executive and Matthew Whittaker senior economist, both at the Resolution Foundation.

This post originally appeared on the Resolution Foundation blog.

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Heathrow decision: 6 things we learnt about the third runway plans

Affected homeowners will get 25 per cent extra for their homes. 

After years of ferocious campaigning by both Heathrow and Gatwick to be the site of a new airport runway, Heathrow has triumphed. The government has accepted the recommendations of the Airports Commission and backed a third runway at Heathrow.

Confirming the decision, the Transport secretary Chris Grayling said: “The decisions taken earlier today are long overdue but will serve this country for generations to come."

So what happens now? Here is what we learnt:

1. It’ll be a while

Grayling said the draft policy statement will be published early in 2017. There will then be a full public consultation, before MPs get a chance to debate the details and vote on the proposals.

Only after that, will Heathrow be allowed to submit a planning application for the third runway.

2. Affected homeowners get a bung

Building a third runway will require the destruction of local homes, and Grayling said these homeowners can expect to be paid 25 per cent above the market rate. All associated costs, like stamp duty and legal fees, will be covered. 

3. So will the local communities

The government is promising £700m for insulating homes against noise, and it is floating the idea of a Community Compensation Fund that would make a further £750m available to local communities, although the details will be confirmed through the planning process. 

4. No flying at night

The government is demanding that flights are banned for six and a half hours a night to give locals some peace. Heathrow will also be expected to continue to give local residents a timetable of aircraft noise.

5. Air quality matters

Heathrow’s successful proposal included an ultra-low emissions zone for all airport vehicles by 2025. The airport can only get planning approval if it can meet air quality legal requirements. 

6. There will be a by-election

Zac Goldsmith, the MP for Richmond Park, is to resign in protest at the decision, and is expected to run again as an independent candidate. Speaking in the Commons, he warned that the decision to choose Heathrow was full of legal complexity and "will be a millstone around the government's neck". 

Julia Rampen is the editor of The Staggers, The New Statesman's online rolling politics blog. She was previously deputy editor at Mirror Money Online and has worked as a financial journalist for several trade magazines.