Think at London Business School
Friday 12 February 2021
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By Gary Dushnitsky, Sayan Sarkar
As UK government debt crashes through historic milestones how high can it go? Can the government afford to help struggling households and instil confidence in wealthier households to spend?
In a recent Wheeler Institute webinar, Andrew Scott and Paolo Surico, Professors of Economics at London Business School, join Elias Papaioannou, Academic Co-Director of the Wheeler Institute, to explore the limits and implications of UK government and household debt.
Professor Surico has been one of the leading voices working on household and corporate debt. In the webinar, that is part of the Institute’s series focusing on the UK economy, he sets out the evidence for different households’ ability to pay off debt.
After the 2008 crisis, UK household debt peaked, at almost 1.5 times the level of income, and in the fourth quarter of 2019, household debt is on average 1.3 times income. This suggests households have some headroom, but this is only part of the story, says Professor Surico.
“The top 25% of the income distribution accounts for almost 50% of the decline in aggregate consumption”
Looking at the household balance sheet of the UK economy, Professor Surico’s research compares three housing tenure groups, which are evenly represented: outright owners, mortgagors, and renters.
When you figure out how much the level of debt is in relation to the liquid wealth that they hold, as Professor Surico has, you quickly establish who will suffer most if debt increases.
His research has found that outright owners in the UK have significant liquid wealth but very little debt and so they are unleveraged. This means they can absorb an income shock without cutting back on essentials or even discretionary purchases. This means they can absorb further debt without cutting back on essentials or even discretionary purchases.
On the other hand, at the bottom of the wealth distribution, despite having less debt in total, the poor are more exposed. This is because their debt is higher than their level of wealth, therefore a poorer household in this situation is highly leveraged. This means they are likely to have to cut spending on essentials and certainly any discretionary spending, if they have any. This group also has no savings and, by definition, has more expensive unsecured loans and are living a hand-to-mouth existence.
The mortgagors in the middle are a very diverse group. The median in this group have comparable liquidity to the renters. These are households who have bought homes for the first time and who have stretched themselves to do so, by cashing in savings for a deposit. Even before COVID-19 struck, Professor Surico found, that a third of British people are spending every penny of income they receive.
The findings for renters looks worse when you consider employment. While mortgagors are typically in jobs they can do from home and are less likely to be furloughed, a higher share of people that have been furloughed are renters. In fact, people at the bottom of the income spectrum are seven times more likely, to be in a sector that has been shut down because of the crisis than people at the top of the income distribution. People on a low income tend to be younger, tend to be less skilled and tend to be renters.
In a collaboration with Sinem Hacioglu and Diego Kaenzig, Professor Surico and his colleagues looked at household spending across the outright owner, mortgager and renter groups. They found that, while spending has been cut across households, it was the wealthier households that cut the most in absolute terms. These cutbacks, across a discretionary basket, do little to harm their standard of living but does most to harm aggregate demand in the economy. The top 25% of the income distribution (which features far more mortgagors than renters) account for almost 50% of the decline in aggregate consumption associated with the COVID-19 crisis
“The question should not be whether the government can afford to help… but whether it can afford not to”
The mortgagors have cut spending too, but they’ve focused their cash on repaying their existing debts. The renters are cutting the least because they have little or no discretionary spending, but they will experience the greatest fall in their standard of living as they borrow more or cut essentials.
It is a picture that is not reflected by government policy, which Professor Surico has found is focused more on helping mortgagors, through payment holidays, despite only one-third of this group facing liquidity trouble.
The question should not be whether the government can afford to help these vulnerable groups but whether it can afford not to, says Professor Scott.
While, UK government debt has jumped to its highest level since 1963, in terms of its ratio to GDP, and April was the biggest ever month in borrowing throughout all of history these are not unprecedented times. Professor Scott expects borrowing to exceed the 90% of GDP incurred during the 2008 financial crisis and reach 120-150% of GDP.
However, he stresses that it is important to think of debt as a buffer, a way of responding to shocks that happen in the economy and it should not be policymakers’ main economic target. In response to a one-in-50-year pandemic, it is entirely plausible that your debt should take 50-years to pay back, he says. A government balance sheet is not like a household balance sheet.
Looking over a 300-year sample of UK debt, a level of 120-150% of GDP isn’t unmanageable.
Ultimately, Professor Scott believes, the UK government is well placed to grow its debt and pay it off. And as the pandemic stalled the economy rapidly, it will also improve more rapidly than other recessions.
Based on these findings, the professors are recommending the government take these three steps to retarget funding to the hardest hit: