Uk Debt On The Rise
The outstanding debt of the UK household sector moved above £1,000 billion in 2004, equivalent to around 140% of household income (compared with around 105% ten years earlier). The rapid accumulation of debt has raised questions about the ability of people to repay what they owe, especially in the event of a sudden change in economic circumstances. This could have implications for both monetary policy, if the combination of high debt levels and a worsening economic outlook were to cause a slowdown in spending by households, and financial stability, if an increasing number of households were to default on their debts. It is therefore important to understand what lies behind the increase in debt and to assess its future sustainability.
Debt sustainability cannot satisfactorily be addressed by looking at the aggregate balance sheet of the household sector alone. There are substantial differences across households and shocks to the household sector are likely to affect different households in different ways. This paper proposes a framework for understanding aggregate indebtedness in terms of individual optimising decisions and adopts a model to explain the rise in borrowing. The model is set up to be consistent with the aggregate, cross-sectional and cohort experience of British households using information from the British Household Panel Survey. This process of calibrating the model reveals some inconsistencies between the basic life-cycle model of household behaviour used here and what is observed in practice. In particular, the level of debt is lower than expected at both extremes of the age spectrum. We therefore modify the basic model so that it can account for the observed cross-sectional balance sheet position of British households.
The model may be used to look at how balance sheets might develop in the future, on the assumption that it adequately captures current and future household behaviour and dependent on future trends in its determining factors such as real interest rates, house prices and incomes. This can be used as means of assessing the 'sustainability' of recent high debt levels. Sustainability of debt can be judged in two ways: whether debt will remain at or above current levels; and whether it is affordable. On the first test, this depends critically on the expected path for key determining variables. The paper shows that different future paths for the real interest rates could lead to a higher or lower debt-income ratio, suggesting that sustainability can only be assessed conditional on a view of how these determining factors are likely to develop. In neither case, however, do recent debt levels look unaffordable to the typical individual. Even if real interest rates were to revert to the higher levels seen in the late 1990s, the future consumption of even the most indebted cohorts would exceed that enjoyed by older cohorts today, reflecting the impact of past and future economic growth. Of course, the emergence of unexpected shocks would have an adverse impact on households. We have illustrated the effect of higher interest rates, lower house prices and lower pension incomes. All would cause a contraction in household spending and change the equilibrium debt-income ratio. The more severe the shock the more likely that the sustainability of debt would become an issue. While we are unable to assess the likelihood of such shocks with the current model, it is nevertheless a useful tool for assessing the severity of their impact.
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Article by O. Downing from Birmingham