Simon Hebb: There’s no going back to the era of easy credit

Debt can be a good thing. Most of us have bought our homes with a mortgage, and then established a plan for the ultimate repayment of it. In recent years, however, the growth of indebtedness in the UK seems to have got out of hand, and plans to repay the loans seem to have been forgotten. At this stage debt is no longer such a good thing.

Recent analysis by Pricewaterhouse-Coopers shows that total UK indebtedness, which includes the debts of households, companies, banks and the Government, rose from 200 per cent of total economic output in 1987 to 540 per cent in 2009.

By this measure, the UK’s borrowing grew by more than any other advanced economy during this period, and now is on a par with that of Japan, which is constantly castigated for having so much debt.

To express this in a more meaningful context, if one had bought a house with equity of £100,000 and a mortgage of £200,000 in 1987, by 2009 the same amount of equity needed to be paired with a loan of £540,000 to buy the same house.

To many of us, such debt seems terrifying, but banks were happy to make loans without house buyers putting in any equity at all.

Now, of course, banks are asking for higher proportions of equity when they approve new mortgages; in other words there has been a dramatic reversal of their lending policies.

The same can be said of both the Government’s fiscal policy and the shift in corporate behaviour towards strengthening their balance sheets. Households too are repaying loans.

Evidently, there has been a growing recognition that collectively we have spent tomorrow’s income yesterday, and that we can no longer go on doing it. We have to live increasingly within our means.

That would not be so difficult to bear if our disposable income, after taxes and the impact of inflation on prices, was growing; but for most of us it is not. According to Deloittes, this year is likely to be the fourth year in succession that real earnings have fallen. The last time this occurred was in the 1870s. Clearly the cause of the squeeze is more than just coalition fiscal policy.

The one aspect of the domestic cash flow equation which has been positive has been the monthly instalments on the mortgage. With interest rates at very low levels historically, this burden has fallen for many householders, but bank rates cannot realistically fall further. The question which now arises is when they will start to rise, and this is generating heated debate among economists.

It is our view that interest rates will remain low for several years. We believe that the inflation statistics show the impact of rising commodity and import prices together with the increase in VAT, and that this impact will fall away during 2012.

Moreover, we do not see signs of these influences being transmitted into earnings increases, because with so many public sector job losses the employment market remains fragile. We do not believe that inflation gives the Bank of England cause to raise base rates, as this would remove the last remaining prop for household spending.

The Bank of England is unlikely to raise interest rates before real earnings start to rise again. That is unlikely to occur before 2012. Even then, given the level of indebtedness, rates are likely to remain historically low for a long time so that servicing the loans remains affordable.

The affordability of loans will remain good, but that does not mean that it will become easy to take out new ones. Consumers will have to contribute plenty of equity, and businesses will require robust business plans. Arrangement fees and other costs will remain high. The high street banks have to rebuild their balance sheets, and thus they are likely to remain far more risk averse than they were prior to the credit crisis. Indeed their previous behaviour is now seen as having been rash.

Self-evidently this is neither good news for savers, nor positive for people who need a new loan. The consequences of the “you can have it all now” mentality lie before us. It may seem unethical that the beneficiaries of this rash and selfish behaviour can impose a drop in living standards upon the rest of us, but there really is little alternative.

Simon Hebb is a chartered investment manager at Harrogate-based Gore Browne Investment Management.