UK prime minister Tony Blair is facing the biggest test of his political career as he tries to persuade the British public to support military action against Iraq in alliance with the US. But his government is not just dealing with a major foreign policy problem. The UK economy is also under scrutiny.
In all of the Anglo-Saxon economies – the US, the UK, Australia and New Zealand – there are huge consumer debt bubbles. But the UK has the biggest. It might deflate slowly or burst suddenly.
As UK house prices rocket by more than 25% a year, the government, the Bank of England and most analysts continue to deny that there is a debt bubble. Debt is not at danger levels, and the consumer is still spending because incomes and property values are rising and unemployment is at historical lows.
Irrational optimism?
Are the optimists right? They admit that house prices are high in relation to income and rents. And the ratio of household debt to income has risen. But the level is not much higher than in the late 1980s during the last housing boom. And the cost of servicing debt has never been lower. Mortgage interest rates would have to double before monthly payments reach the 1990s’ average.
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These arguments, though, are based on looking backwards, denying recent developments or on not recognizing the forces that are set to burst this bubble. UK household debt to GDP has risen significantly in just the past year. The same has happened to debt in relation to household assets. That’s because the continued fall in equity prices has reduced wealth, at a time when mortgage borrowing has risen fast. Indeed, if liabilities are measured against liquid financial assets alone, UK households have rarely been as vulnerable. Mortgage equity withdrawal is at record levels.
What has kept the UK economy motoring faster than those of continental neighbours has been growth in services and consumption. These have expanded twice as fast as domestic production. But this growth imbalance means that imports are filling the gap. Net external liabilities are now at record levels.
Driving the UK economy have been financial, business and property services. They now contribute nearly 30% of annual UK output and an even higher proportion in London. The capital’s weight in the UK economy – contributing 19% of annual GDP and 17% of employment – is so great that any property downturn will disproportionately affect the economy.
UK banks are lending to the property sector, not to industry, with over 40% of outstanding loans secured on property compared with 25% in the US. UK bank lending to commercial real estate is growing at an annual 20%, while lending to industry is rising at just 4%. And yet commercial property capital and rental values are falling and the rate of return on capital in manufacturing is at near recession lows of 6%. No wonder UK business investment is falling at a 10% rate.
Some optimists recognize there is a consumer bubble but reckon there’s still life in the property market to keep it inflating for longer or allow it to deflate slowly rather than burst. Households find property affordable because incomes are still rising and interest rates are low. The key factors supporting the housing market are income growth and employment. These look set to slow, but when?
If household spending holds up until business investment and government spending kick in, trend real GDP growth of 2% to 2.5% will be sustained. However, if domestic demand slumps before investment picks up, the bubble might burst. There are signs that consumer income growth is already slowing. Top-end property is suffering, with a 10% fall in homes costing more than £1 million. So the bubble might burst this year.
Slowing domestic demand – because consumers are weaker and domestic industry is in recession – means that the UK’s positive growth differential over the eurozone will disappear. A weaker currency should result. The euro is already appreciating against sterling. A weaker UK economy and the bursting of the property bubble will accelerate that process.
Britons opposed to eurozone membership outweigh those in favour by over 30 percentage points. So the government is likely to put off the issue until after the next general election. If this happens will sterling strengthen against the euro? I think not. Entry would still be on the agenda for 2006. In the meantime, the economy’s debt bubble will burst. That will be the driving factor both for sterling and UK equities.
Of course, there is another bubble set to burst – high wages in the eurozone. Low growth and a strong currency will eventually bring adjustments here. Then the euro will weaken, offsetting sterling weakness – but only after the euro strengthens. The UK consumer debt bubble is first on the agenda.
