What’s wrong with £1 trillion of debt?

published 31 October 2005

Household debt in Britain last week burst through the £1 trillion mark. But there is no need to panic - at least not yet, says Simon Nixon.

What is a trillion?

For these purposes, it is a million million, or a one followed by 12 noughts. This is, of course, the American definition of a trillion and not to be confused with the traditional British definition of a trillion, which holds it is a million million million. Nonetheless, it is still a colossal amount of money and is almost equal to Britain's entire annual GDP. What is even more remarkable is that the value of our debts has doubled in just seven years. When Tony Blair took office in 1997, we owed just £500bn. As it is, every man, woman and child in Britain now owes an average of £17,000.

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Is debt such a bad thing?

No. Debt is the lifeblood of every modern economy. It is the means by which wealth is mobilised and channelled to those who can make the best use of it. Debt allows firms, governments and individuals to invest in their futures, while enabling the providers of capital to earn a return on their assets. Indeed, the value of debt outstanding is neither here nor there, since the debt will never be repaid. The only thing that really matters is what use all this debt is being put to and whether borrowers can afford to pay the interest.

What use is the debt being put to?

There's no doubt that enormous sums are being frittered away on a high-street spending splurge financed by credit-card debt. On average, we owe some £5,350 each on credit cards - a total of £55bn or 5% of total borrowing - more than double what we owed just five years ago. Meanwhile, a further £122bn is in other forms of unsecured lending, including personal loans and overdrafts. But the bulk of the £1 trillion - some 82% of £822bn - is in the form of mortgage debt.

Is this something to worry about?

Not necessarily, since our £1 trillion worth is backed up by £3 trillion worth of financial assets. Indeed, the value of our homes has risen even faster than our debts, so the ratio of debts to assets has in fact risen from one to 2.5 in the mid-Nineties to one to three today. Besides, few people are yet struggling with their interest payments: interest as a proportion of net income was just over 7% in the first quarter of this year, which was low by historic standards, and less than half the peak of 15% in the early 1990s. Similarly, survey after survey shows that most Britons are comfortable with their level of credit-card debt, that those who owe the most tend to be those most able to afford it, and that most pay off their balance in full every month.

So why the doom-laden headlines?

The big fear is over interest rate rises. Will house prices crash? Will consumers rein in their spending, triggering an economic slowdown? The consensus is still that there won't be a house-price crash. Nationwide concluded that house prices rose 20% in the year to July - the fastest in more than a year. But other recent surveys indicate that rate rises are beginning to bite. The Royal Institution of Chartered Surveyors says house-price inflation slowed in June to its slowest in ten months; Hometrack says average asking prices fell 0.5% in July. For several leading economists, a full-blown crash is on the cards. Roger Bootle of Capital Economics expects prices to fall 20%, and the National Institute of Economic and Social Research reckons house prices are overpriced by 30%.

Are people taking these warnings to heart?

The evidence is mixed. Borrowing jumped faster than expected last month, suggesting consumers remain bullish about their prospects. On the other hand, new figures show that spending on the high street slowed markedly in July. The British Retail consortium said its index of high-street prices fell 0.7% last month to its lowest level this year after a second month of steep sale cuts. Similarly, the Confederation of British Industry said the number of retailers reporting higher sales than last year fell by half between June and July. Nationwide reports that one in four consumers expect to cut their borrowings over the next six months, compared to 11% who say they will borrow more.

What is the crunch point for interest rates?

With every turn of the interest-rate screw, more borrowers find themselves in difficulties. The National Consumer Council reckons around six million families in the UK are on the brink of financial difficulties, while Citizens Advice reports a 44% rise in numbers seeking help with debts over the last six years. These numbers are sure to rise over the next year, particularly as those who took advantage of record low two-year fixed-rate mortgage deals last year come off those rates. But while this points to a degree of belt-tightening, it is unlikely to lead to the widespread misery of the early Nineties. For that, reckons the Financial Services Authority, interest rates will have to hit 6.5% - something few are predicting.