Don't panic

UK – debts again

The UK and its stock of debt returned to the spotlight this week. A nasty inflation ‘surprise’ was followed by a big jump higher in base interest rates from the Bank of England with the promise of more still. Millions of UK households face step changes in their debt servicing costs in the months and quarters ahead.

Meanwhile the re-crossing of the 100% debt to GDP line for government borrowings fed yet more doom-laden forecasts - The UK is stuffed in the short term and our children (and theirs) will pay for our profligacy, complacency and more besides? This week we focus on the UK mortgage strains ahead and provide a few reminders on the government debt pile.

Inflation and interest rate rises

Genuine shocks, such as the pandemic, perhaps the coming El Nino and other suchlike, are mostly unavoidable. In their midst and aftermath, the central bankers have one of the toughest jobs out there. The all-important credibility of their institutions depends on their ability to retain our fear/expectation of them as an inflation fighting force.?

When the inflationary hump(s) arrive out of the blue, the race begins. Every day that the incoming news and experience of inflation jars with that rough 2% expectation is another exposed to the contagion. The central bankers feel they can ultimately get in front of much worse and more durable struggles, but only by inflicting a degree of economic pain.

The UK currently stands out as the one of the major economies where this inflation contagion is furthest along. Core inflation and wages both point to changing expectations from consumers and businesses. The understandable response to this increasingly stiff interest rate environment centre around a threat to the mortgage book.?

How much pain?

Of course, not everyone in the UK has borrowing associated with their home. There are around 7.5m owner occupied mortgages, just less than 30% of households. More than half of these have already absorbed the stepped-up interest rates.[1] We have pointed out before that much of this mortgage debt rests on shoulders able to bear it, even at those higher interest rates - there is some overlap here with the parts of society that have excess savings still to deploy.

That is not to make light of the stress and difficulty that these higher interest rates will inflict. Nor the potential for more concentrated areas of difficulty. It is more a reminder to treat some of the more lurid doomsday predictions with care. There are paths out of this moment without crisis.

One thing some are keeping an eye on nonetheless is the impressive resilience of house prices. They have so far not dropped in the UK as they have in other economies with (roughly) comparable mortgage burdens. Households have so far managed.

However, in the context of a necessary humility as to where short-term interest rates will ultimately peak, this could change. (Figure 1) The further the Bank of England goes, the more we could see those straining rivets spring major leaks, to flog a previous analogy. In residential housing, you could find the supply of accommodation jumping if enough stress was applied. House prices could fall sharply, sucking wider confidence with them.

As noted above, we’re not sure that should be a central scenario, however compellingly gory. Disinflationary forces are gathering a little more convincingly abroad, as they may be soon domestically. Beyond this difficult moment, the future is likely a little brighter than the ever-gloomy consensus implies.

Government debt

The other notable debt-based headlines of the week surrounded UK government borrowing relative to the economy’s output (GDP) crossing a line uncrossed since the 1960s. This is a subject that we have written and spoken on plenty.

The credibility of the UK government as a borrower in international markets (which influences the interest rate would be lenders are willing to offer) is not simply a function of how much debt there is. This is surely one of the lessons we can take from the brief premiership of Liz Truss and the time since. Much of the UK government’s ability to borrow cheap and long rests on the credibility of its institutions and the movers and shakers populating them. Sterling’s very different posture now relative to the wild days following the mini budget, despite similar levels of threat from Bank of England monetary policy, speaks volumes.

Debt to GDP is an apple and pears metric in any case.[2] There are surely limits to what a country can borrow, but those limits can change and are potentially some way off. Even if higher real interest rates are here to stay. Meanwhile, the UK has borrowed more than double as a percentage of her output in the past, without it visibly crimping ensuing, ultimately inclusive growth.

In fact, between Waterloo and the end of the 19th century, debt to GDP in the UK went from around 250% to less than 25%. That this massive, sustained reduction in (proportional) borrowing coincided with a living standard leap for UK society should help guide how we weight arguments in this area.

The industrial revolution of the time was the driving force here and was unrelated to the debt pile.[3] There is some rhyme perhaps in the fact that another industrial revolution lies ahead, with large language models potentially at the helm.

Conclusion

Difficult times ahead no doubt. The UK economy has plenty of challenges to overcome, some self-inflicted. However, there is also considerable opportunity. The UK remains blessed with often underestimated/unmentioned comparative advantages. The institutional framework appears to have held up impressively well to the political and other shocks of the last few years. We have several universities, capital and regional cities that stand toe to toe with the best in the world. These allied to some core sectoral strengths can be important as the world grapples with this incoming technological leap. Do not despair. The Ashes is not lost yet.

[1] “…by the end of June, 4.2 million households in Britain will have seen their mortgage rate change since the Bank of England started raising rates in December 2021. This is around half of all mortgaged households (56 per cent), with the remaining 3.3 million households (44 per cent) yet to see their fixed-rate deal expire.” – Resolution Foundation

[2] https://bcf.princeton.edu/events/jason-furman-on-when-if-ever-should-we-worry-about-the-debt/

[3] There is quite a huge literature on war and economic growth, and some interesting strands around state formation in Europe – “war made the state, and the state made war”??

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