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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Why Angela Merkel's comments about the UK and US shouldn't be given too much weight

The Chancellor's comments are aimed at a domestic and European audience, and she won't be abandoning Anglo-German relationships just yet.

Angela Merkel’s latest remarks do not seem well-judged but should not be given undue significance. Speaking as part of a rally in Munich for her sister party, the CSU, the German Chancellor claimed “we Europeans must really take our own fate into our hands”.

The comments should be read in the context of September's German elections and Merkel’s determination to restrain the fortune of her main political rival, Martin Schulz – obviously a strong Europhile and a committed Trump critic. Sigmar Gabriel - previously seen as a candidate to lead the left-wing SPD - has for some time been pressing for Germany and Europe to have “enough self-confidence” to stand up to Trump. He called for a “self-confident position, not just on behalf of us Germans but all Europeans”. Merkel is in part responding to this pressure.

Her words were well received by her audience. The beer hall crowd erupted into sustained applause. But taking an implicit pop at Donald Trump is hardly likely to be a divisive tactic at such a gathering. Criticising the UK post-Brexit and the US under Trump is the sort of virtue signalling guaranteed to ensure a good clap.

It’s not clear that the comments represent that much of a new departure, as she herself has since claimed. She said something similar earlier this year. In January, after the publication of Donald Trump’s interview with The Times and Bild, she said that “we Europeans have our fate in our own hands”.

At one level what Merkel said is something of a truism: in two year’s time Britain will no longer be directly deciding the fate of the EU. In future no British Prime Minister will attend the European Council, and British MEPs will leave the Parliament at the next round of European elections in 2019. Yet Merkel’s words “we Europeans”, conflate Europe and the EU, something she has previously rejected. Back in July last year, at a joint press conference with Theresa May, she said: “the UK after all remains part of Europe, if not of the Union”.

At the same press conference, Merkel also confirmed that the EU and the UK would need to continue to work together. At that time she even used the first person plural to include Britain, saying “we have certain missions also to fulfil with the rest of the world” – there the ‘we’ meant Britain and the EU, now the 'we' excludes Britain.

Her comments surely also mark a frustration born of difficulties at the G7 summit over climate change, but Britain and Germany agreed at the meeting in Sicily on the Paris Accord. More broadly, the next few months will be crucial for determining the future relationship between Britain and the EU. There will be many difficult negotiations ahead.

Merkel is widely expected to remain the German Chancellor after this autumn’s election. As the single most powerful individual in the EU27, she is the most crucial person in determining future relations between the UK and the EU. Indeed, to some extent, it was her intransigence during Cameron’s ‘renegotiation’ which precipitated Brexit itself. She also needs to watch with care growing irritation across the EU at the (perceived) extent of German influence and control over the institutions and direction of the European project. Recent reports in the Frankfurter Allgemeine Zeitung which suggested a Merkel plan for Jens Weidmann of the Bundesbank to succeed Mario Draghi at the ECB have not gone down well across southern Europe. For those critics, the hands controlling the fate of Europe are Merkel’s.

Brexit remains a crucial challenge for the EU. How the issue is handled will shape the future of the Union. Many across Europe’s capitals are worried that Brussels risks driving Britain further away than Brexit will require; they are worried lest the Channel becomes metaphorically wider and Britain turns its back on the continent. On the UK side, Theresa May has accepted the EU, and particularly Merkel’s, insistence, that there can be no cherry picking, and therefore she has committed to leaving the single market as well as the EU. May has offered a “deep and special” partnership and a comprehensive free trading arrangement. Merkel should welcome Britain’s clarity. She must work with new French President Emmanuel Macron and others to lead the EU towards a new relationship with Britain – a close partnership which protects free trade, security and the other forms of cooperation which benefit all Europeans.

Henry Newman is the director of Open Europe. He tweets @henrynewman.

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