The UK's debt dilemma

By Myles Neligan
BBC News Online business reporter

Credit cards: Debt made easy?

Last week, the Bank of England had to decide once again between cutting interest rates in order to make life easier for industry, and leaving them on hold to guard against newly resurgent inflation.

In the event, the Bank left rates unchanged, disappointing manufacturers, but earning plaudits from economists worried that a weaker pound may fuel inflation further by pushing up the price of imported goods.

But despite the inflationary risk, the Bank is unlikely to have considered the other remaining option - putting up rates - partly because doing so could force Britain's heavily indebted consumers to stop spending, thereby depriving the economy of its main growth engine.

People talk about a global economic recovery, but that is a gross assumption

Professor Wynne Godley Cambridge University

For professor Wynne Godley of Cambridge University, the economy's dependence on spending by consumers - and their reliance, in turn, on borrowing - is a ticking time-bomb which policymakers seem powerless to defuse.

"We are in a very difficult and dangerous situation. The trouble is that we've let it get out of hand, and it's very difficult to know what to do," he told BBC News Online.

Spend now

In a paper, co-written with Alex Izurieta of the Cambridge Endowment for Research in Finance, professor Godley lays bare the full extent of the problem.

The authors confirm that growth in the UK has been fuelled largely by consumer spending for the past five years.

Moreover, they say, this spending has been funded in large part by debt, with lending to consumers soaring from 4.5% of disposable income in mid-1997 to nearly 17% by the end of 2002.

Ordinarily, this spending spree would have created a runaway boom, prompting corrective action in the form of tax increases or higher interest rates.

But, as it coincided with a sharp fall in business investment and exports, debt-happy consumers were allowed to spend on unchecked.

Pay later

Now, professor Godley believes, the time is fast approaching when the debt time-bomb may explode, with serious consequences for the economy.

Weaker house prices could spell trouble

One likely trigger would be the end of the housing boom.

With the property market now showing signs of cooling, there is a risk that homeowners will become reluctant to fund consumption by borrowing against the rising value of their houses - even though low interest rates would make their repayments affordable.

This could derail one of the implicit assumptions underpinning the Treasury's latest forecast of 3% growth a year between now and 2005 - that private consumption, supported by sustained growth in debt, will hold steady.

False hope

Nor does professor Godley share the Treasury's view that a global recovery starting in 2003 will boost export demand by 7% a year, allowing industry to shoulder some of the burden of driving economic growth.

"People talk about a global economic recovery, but that is a gross assumption," he says.

The US, he believes, is locked in a 'growth recession', with moderate economic expansion accompanied by rising unemployment, while the eurozone economies remain constrained by self-imposed spending and borrowing limits.

Professor Godley and Mr Izurieta calculate that if exports grew by a more realistic 3% a year, and if at the same time consumers stopped taking on more debt, the UK would grow by just 1% a year between now and 2005.

This, they say , would be "far below the growth of productive potential, and certainly slow enough to entail a large rise in unemployment".

Dead end

Nor are there any easy ways out. Slashing interest rates aggressively would devalue the pound and boost exports, but would also perpetuate the debt problem.

In any case, the remit of the Bank of England's rate-setting monetary policy committee is limited to keeping inflation at or around the Treasury's 2.5% target.

Allowing extra government spending to take up the slack in the economy, meanwhile, is precluded by Chancellor Gordon Brown's "Golden Rule" - which states that it is acceptable to borrow to invest only if any additional debt is repaid over the economic cycle.

Professor Godley traces the origin of the UK debt bubble back to the early 1980s, when a range of consumer credit controls and restrictions on mortgage lending were removed.

"That should never have happened," he says. "We are now at a point where the problem doesn't have a clear solution."