Prepare for the credit-card crunch

Stand in the middle of any high street in Britain this weekend and you'll see hundreds of people handing over small strips of plastic. In exchange, they'll be taking home bags full of toys, clothes, books, games, and all the other things they plan to give to their families on Christmas Day. But one in every £10 spent on all those credit cards won't ever be paid back.

Britain, in common with many other countries, is sleep-walking into a credit-card crunch. Much of the country is still spending wildly on credit cards, living way beyond its means, and indulging in a fantasy prosperity, wilfully encouraged by irresponsible bankers. Sometime soon, there will be a Dubai moment a point where everyone realises that the whole edifice is built on sand. When that happens, there will be a nasty hit to consumer spending and a lot of red ink for the banks. And the flimsiness of the economic boom in the UK during the past decade will be painfully exposed.

Credit-card debt is now a huge part of the British economy. In 1992, according to the Bank of England, the British were borrowing around £2.8bn a month on credit cards. Now it is above £10bn a month (£1 today equates to 64p in 1992). It peaked last December one final festive splurge before the credit crunch hit, perhaps when we spent £12.1bn of plastic money we didn't have.

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Sure, credit cards are a way of paying for things as well as a way of borrowing money. And at least some of us pay off the balance every month. But the balance of credit-card debt is still rising. The latest monthly statistics, published on Monday, showed a slight decline in overall consumer debt. Yet despite that fact, outstanding credit-card debt still rose by £134m. Overall, the amount of debt owed on British credit cards is now close to £60bn.

We don't know precisely how that will play out in a recession. In the last downturn, in the early 1990s, only about £10bn was outstanding on credit cards and defaults peaked at 4%, before dropping back to 2%. But so far the signs aren't good.

According to the ratings agency Moody's, the charge-off index (the technical term for spending on your card and not paying the money back) hit an all-time high of 11.8% in September, having doubled since the first quarter of 2008. Nor does the agency reckon the outlook is very encouraging it has warned that a second splurge in Christmas spending may well trigger another spike in bad debts in the early part of the new year.

Unemployment forecast to rise steadily through next year will push even more people to the point where they can no longer meet the payments on their cards. Don't be surprised if the rate at which people are reneging on their debts ticks steadily up to 13% or 14% as 2010 progresses.

The conclusion is simple. A significant minority are clearly spending money they don't have, and have no serious prospect of earning either. Sadly, the law makes it easy to rack up debts then walk away from them. When your credit-card debts become unaffordable, simply declare yourself insolvent. Figures for the latest quarter show personal insolvencies up year-on-year by 28%, and now running at the highest level since records began in 1960.

So far, the banks have just about managed to get away with it by passing the costs on to responsible customers. As interest rates have tumbled, those for credit cards have barely changed, pushing the margins up to 15% or more between what it costs banks to access money and what they charge people for borrowing it. That has allowed them to maintain their profits despite the hammering they are taking on bad loans. Barclaycard, for example, managed to increase its profits slightly this year, despite a doubling of bad-debt charges.

The trouble is, that was a one off. Sooner or later, the banks are going to be drowning in a sea of unpaid loans. They can't keep passing the cost on to the rest of their customers in higher interest rates and higher charges. And the wholesale markets are going to take fright. Just like sub-prime mortgages, credit-card debts are bundled up and sold around the world. But who will want to own British credit-card debt when one in £10 doesn't get repaid and you have no legal sanction against the borrower, nor any kind of asset you can call upon?

At some point, this bubble is going to burst. Many credit-card lenders will have to withdraw from the market in much the same way as most of the self-certificate, buy-to-let mortgage lenders have done. The rest will have to curtail their lending, insisting on better credit records, and perhaps even demanding security for their loans. That will trigger a big hit for the British economy. Right now, at least £1bn a month of consumer spending is plastic money that is simply magicked out of thin air.

Add to that the fact that one in every £4 spent by the government is money that is similarly magicked from inside a computer at the Bank of England and the extent to which the British economy exists in a twilight zone of pretend money becomes painfully clear. At some point it will disappear and when it does, the results won't be pretty.