Is Britain sinking under a sea of debt?
Speech to the Centre for Policy Studies
Ladies and gentlemen, our green and pleasant land is in the red.
According to the Bank of England, household debt is at record levels.
In September of this year total lending to individuals passed through the £900 billion barrier and has today reached £916 billion.
Moreover this record sum is growing at a record rate.
The growth in household debt, both secured and unsecured, is currently running at over 10% per year.
If that rate is maintained, then total lending to individuals will, by the end of next year, break through the £1000 billion barrier.
That is £1 trillion - a number normally used to enumerate the US federal debt.
So should we be worried?
There are those that say that we should worry, but there are others equally certain that we must not panic.
The pessimists include Jan Hatzuis, senior economist at Goldman Sachs, who points out that: "eleven per cent household debt growth in a stable interest rate environment is not sustainable."
John Butler of HSBC, is among many leading economists who have expressed concern over record debt-to-income ratios. He warns that "households will feel the squeeze at considerably lower interest rates than in the past. Base rates of 5% will create the same burden - interest and mortgage repayments as a proportion of disposable income - as base rates of 10% did a decade ago."
City analyst Richard Ratner, of broker Seymour Pierce, is succinct: "crunch time is coming," he says.
Some analysts cite the upward trend in personal bankruptcies or the recent figures on the fragility of consumer confidence as evidence that the crunch is indeed on its way.
The optimists point out that debt servicing costs are low and stable - at around 10% of disposable income, a level that not changed since the mid-nineties.
Sir Andrew Large, the Deputy Governor of the Bank of England, argues that given these low costs: "Servicing high levels of debt seems quite realistic."
While no one argues that the current rate of growth in household debt is sustainable over the long-term, Sir Andrew hints that the Bank's strategy is for a gentle rise in interest rates, in order to shift our personal finances to a lower gear: "A variety of things could get people to behave differently," he said in November, "this could come if they felt that interest rates might rise - and we did raise them modestly earlier this month."
The Bank believes that such an adjustment should be fairly painless. Appearing before the Treasury Select Committee last month, representatives of the Monetary Policy Committee reassured MPs that it would take a 'very, very sharp' fall in house prices to generate the negative equity problems of the early nineties.
Many independent analysts also share in this cautious optimism, such as David Page of Investec, who with "fingers crossed" is "looking for a fairly soft landing in the economy."
So far as the short-term is concerned, I count myself among the cautious optimists.
While it may be the case that the consumer will need to play a lesser role in maintaining economic growth in the next few years, there are encouraging signs that other sectors are ready to play a greater role.
There is no reason why household lending should lead us inevitably to the precipice.
And yet, we need to take a step back - not from the brink - but from a debate on debt that places all of its focus on the short-term.
We need to re-focus the debate on the medium-term and the long-term, to consider the place of debt in our economy, and our society, in the years, and decades, ahead.
I start from the premise that debt is rational.
No one doubts the rationality of moving money to wherever it is most needed; but it is equally rational to move money to whenever it is most needed
Borrowing money, and saving it, is how we move money in time - from the present to the future in the case of saving, and from the future to the present in the case of borrowing.
We need to take a similarly rational approach to the implications of historically high levels of borrowing and historically low levels of saving - or, to put it another way, an unprecedented net flow of money from the future to the present.
Panic is not rational.
But neither is complacency.
Evidence of a worrying degree of complacency was, I fear, shown by the Chancellor on 13 November, when he assured the Commons that levels of house prices and mortgage debt were nothing to worry about.
The time has come for us to base long-term policy on a serious, long-term analysis of borrowing and saving in this country, one which takes proper account of house prices and mortgage debt, charting a path between panic and complacency.
First of all, we need to look behind the headline figures on household debt.
While debt helps most people to achieve their goals, for a minority it can tear their lives apart - a minority which clearly tends toward the lower end of the income scale.
But from the aggregate statistics alone one might never know - until or unless the economy as a whole was to suffer.
That is the danger of the short-term, aggregated approach to debt: it excludes the possibility that problem debt in some households can rise to a level that is socially unacceptable before it becomes macro-economically unsustainable.
Right now, there is gradually mounting evidence of a trend in problem debt that, if continued, has serious implications for the future:
· The number of people seeking advice on debt from the Citizens Advice Bureau has increased significantly over the past five years, from about 860,000 new debt enquiries in 1997/98 to well over one million in 2001/02 - a rise of 24%. In particular, this increase was driven by inquiries regarding unsecured consumer debt, which rose by 47%. Other credit counselling agencies also report growing case loads.
· According to the Bank of England, individual insolvencies have been on an upward trend over the same period, with more than 30,000 individuals now going bankrupt every year. This is not a record level; it was higher in the early nineties; but, in the current climate of low and stable interest rates, it is a cause for concern.
· The Bank also reports that credit card write-offs have been on a rising trend 1997. As a percentage of credit card outstandings, write-offs are not yet at a record level - but in absolute monetary terms they certainly are.
If we draw together all these threads, what emerges is a picture in which problems with unsecured debt are on the rise, though not yet at crisis levels.
The people most at risk are people on lower incomes, usually without housing assets.
Young people tend to fall into this category, with many credit counselling experts concerned that 18-to-25-year-olds are running up credit card, overdraft and student debts without much idea as to how they will be repaid. The Department of Education and Skills reports that students are, for the first time, declaring themselves bankrupt in significant numbers.
Problems with secured debt, especially mortgage debt, appear to be shrinking. However, with mortgage interest rates likely to rise, deterioration cannot be ruled out - with the poorest home owners most likely to suffer.
There is a clear need for policies that deal effectively with the social consequences of debt, without distorting macro-economic policy.
The Conservative Party is committed to finding and implementing such policies.
In the months ahead I will be seeking the advice of a wide range of stakeholders - and next year we plan to hold a debt summit to bring together representatives of the credit industry with groups that represent, advise and assist the victims of problem debt.
One thing we already know - the solution to problem debt is not lower base rates.
There is certainly an issue with interest rates charged on some credit deals, particularly in the sub-prime lending sector. However, this problem has not been caused by excessive base rates, which are at their lowest level for a generation.
Given that low rates are typical of most lending, we shouldn't be seeing so many signs of debt stress in our population.
Nor should we be seeing a collapse in the level of savings.
And just as lower interest rates are not the answer to personal debt, low nominal interest rates are not the cause of this lack of saving; in fact, from a macro-economic point of view, this is quite a good time to save.
All of us here have lived through a profound shift in economic conditions.
The old economy of post-war Britain was beset by unstable, and frequently high, inflation rates which eroded the value not only of loans, but also of savings - making it rational for Britain to become a nation that avoided saving and engaged very heavily in borrowing.
Real interest rates were often negative in the 1970s, at times massively so. For instance, in July of 1975 the Bank of England base rate was 11% at a time when the inflation rate for that month was 26.3%.
From our modern day perspective of consistently positive real interest rates, the instability of the mid-70s looks odd.
As The Teacher notes in Ecclesiastes: "the race [was] not to the swift or the battle to the strong, nor [did] food come to the wise or wealth to the brilliant or favour to the learned; but time and chance happen[ed] to them all."
Appropriately, Time and Chance was the title of James Callaghan's autobiography.
Appropriate, because it was his nemesis, Margaret Thatcher, who laid the foundations of a new economy in which time and chance don't go nearly so far in equalising the fates of the foolish and the wise.
In the new economy it is possible to plan for the future.
Savings won't be worn away by inflation.
And nor will debt, which costs less to service in the short-term, but more to repay in the long-term.
The fundamental economic conditions that apply to Britain today mean that it should be as rational to save as it is to borrow: Households should be making choices that relate to their personal circumstances, and those choices - if the long-term policy framework is right - should be balancing out in such a way as to make us not only a nation of borrowers, but also a nation of savers.
This new economy is founded on the macro-economic legacy inherited by New Labour in 1997.
To be fair to Labour, it is a legacy that the Government has, thus far, preserved.
The Government has followed - and, to be fair once again, it has built upon - the framework of monetary control established by Conservative Chancellors, by handing over control of interest rates to the Ban of England: a move on the success of which I have already congratulated Mr Brown.
But I fear that Mr Brown's proper preservation and enhancement of the framework of monetary control has not been matched by the sagacity of his micro-economic policies.
He has, perhaps unwittingly, introduced a number of perverse incentives in relation to both saving and borrowing.
It is these perverse incentives that help to explain the damage which is beginning to be done to our savings culture, for which evidence abounds:
The savings ratio has halved under Labour, a decline that has, according to the Family Resources Survey, left 27% of households with next to no savings at all and a further 23% with savings of less £1,500.
Only this August, Charles Bean, the Bank of England's chief economist, noted that one third of British households have virtually no liquid assets to draw down if things go wrong.
Oliver, Wyman and Co have calculated that the gap between what British households should be saving to assure themselves a comfortable retirement in line with their expectations, and what they do save, is the well known figure of £27 billion per annum.
It was not supposed to be like this. Labour's own objective was to shift the public-private split in the funding of pensioner incomes from 60:40 to 40:60.
In fact, a recent reply to a Written Parliamentary Question reveals that the split has gone the other way - from 58:42 in 1997 to 61:39 in 2000.
What went wrong?
First of all, there was Gordon Brown's raid on pension funds.
This has sucked £5 billion from the pension system for every year of Brown's tenure.
But the cost to the savings culture is more than £30 billion. The true cost is a loss of trust.
As if this were not harm enough, even worse will be wrought by Gordon Brown's penchant for means-testing.
One of the great fault-lines of this Government - evident long before the fault-line between the Chancellor and the Prime Minister became apparent - is the divide between the Chancellor and Frank Field.
One of the few causes of optimism for a Conservative such as myself in 1997 was the sense that, under the inspiration of Frank Field and with the willing consent of the Opposition, the Government was going to move to lessen the dependency of our fellow citizens on the means-tested benefits that do so much to erode the incentive to save.
Once the Chancellor defeated Mr Field, this hope vanished.
More than half of all pensioners are now eligible for means-tested benefits and on current policies this proportion is expected to rise to three-quarters by 2025.
We have commissioned some work from Mercers, the actuaries, who estimate that a typical pensioner couple, living in rented accommodation, would need to have saved £180,000 in addition to the state pension in order to remain free of means-tested benefits throughout retirement.
If they have saved any less than that they will suffer benefit withdrawal (which is effectively a tax) at a rate of between 40% and 85% for part or all of their retirement.
Because all of this will happen decades into the future, it may well be that many people aren't yet directly aware of the effects on the rationality of saving.
But Frank Field has produced anecdotal evidence that some people do in fact already understand the implications of means-testing.
In a pamphlet he writes:
"Most pensioners have children and grandchildren. The message against savings has been passed down the generations. The Government's fleeting attempts to persuade people to save are therefore overwhelmed by the resentment felt by so many of today's pensioners who feel that they have been held up to ridicule by the Government's means-tested strategy."
Whatever may be true of prospective savers, the pensions industry certainly does understand the implications of Labour policy.
They know that they will be accused of miss-selling if they encourage people to save for their retirement under such circumstances.
I believe that the increasing reluctance of the industry to sell private pensions to an increasing number of people, engendered by Gordon Brown's lunge towards a mean-tested retirement regime, is, in the long-term, a bigger problem than the over-aggressive selling of debt by some finance houses.
I have suggested that the long-term effects on household balance-sheets of the low levels of savings are currently being masked by the value of housing assets.
But the long-term effect of low levels of saving on household income and expenditure accounts - people's ability to deal with 'a rainy day' - is being masked by the correlate of high housing asset values: namely the ready availability of mortgage equity withdrawal.
There is evidence to suggest that mortgage equity withdrawal is not only fuelling consumer spending, but also keeping some people out of the trouble normally associated with unsecured consumer debt. According to the Bank of England, the rate of increase in mortgage lending is at a record level, but the rate of increase in personal lending is not - in fact it is currently on a downward trend.
It is certainly the case that mortgage equity withdrawal has increased dramatically since 1999, now accounting for about half of all mortgage lending, which is of course at record levels.
What is all this money being used for?
The Bank of England's inflation report ventures the opinion that although "it is not clear to what extent the current high levels of MEW have funded consumption. There is some evidence of discretionary increases in MEW, and some of this has probably been spent on consumption."
One thing is for sure. Without MEW there would either be less consumption or more unsecured debt.
In effect, people's houses are currently, and painlessly, doing their saving for them - enabling them to draw down equally painlessly on their assets by means of MEW whenever needed.
Short-term and long-term
This arrangement is working well for the economy, but can only do so as long as house prices keep rising.
In the short-term this may well be sustainable, and the MPC is doing its best to move towards a neutral rate of interest at a speed which is consistent with the maintenance of rising housing asset price levels.
As I have said, in the short-term, I am a cautious optimist.
But let us look to the long-term.
Should we rely on rising house prices to avoid the need for savings?
The Government rightly does not think so. The Prime Minister recognises the social and economic value of saving. In a recent speech on welfare reform he told us that:
"Money put aside changes your horizons. It makes you plan, brings responsibility, and offers protection and opportunity. And I want to ensure that those on lower incomes - and the next generation - can share those advantages."
Unfortunately, this admirable statement of Prime Ministerial intent is not matched by Gordon Brown's systematic expansion of means-testing, which - as I have illustrated - is eroding incentives to save.
True, there is a hint of an acknowledgement, in the latest annual report of the Department of Work and Pensions, published in May 2003, which concedes: "It will take time to alter the balance between state and private sector provision."
But this is a masterpiece of understatement. When the form of the state pension is such as to make private saving increasingly irrational for an increasingly large proportion of the population, it will not merely take a long time to alter the balance in favour of private provision; it will take forever, because it will never occur.
If we are to resolve this discrepancy between theory and practice, if we are to begin to restore the long-term to save, we have to establish a different trajectory - one in which dependence on means-tested benefits decreases rather than increases.
The first step is to recreate the incentive for the kind of saving that has traditionally most mattered to most people in Britain.
In other words, we have to begin by giving people a reason to be confident that every pound they put aside during their working life means a pound extra when they retire.
This is the thinking behind our much misunderstood pensions policy. David Willetts and I have both been concerned for many years about the spread of means-testing. The arrival of the Pension Credit makes the problem even more acute. David Willetts has worked over the past year to construct an answer, and we now have one.
Our critics have said that our policy - of raising the basic state pension in line with earnings over the next Parliament and, we hope, over time to the point where it eventually reaches the value of the Chancellor's means-tested benefits, is unaffordable and irresponsible and opportunistic.
They fail to understand the policy.
It is affordable.
It is responsible.
It is principled.
We have carefully costed the proposal over the life of the next Parliament. The gross cost of the earnings link ranges from approximately £385 million to £510 million in the first year, rising to a range of £2,175 million to £2,900 million in year 4.
We have also carefully worked out how these costs can be met. The first point to make is that we do not propose - contrary to Labour propaganda - to abolish the Pension Credit. We intend to keep it in place. But introducing the earnings link for the basic pension reduces the cost of the pension credit and other means-tested benefits to the taxpayer. One million or more pensioners will be floated off means-tested benefits by the end of the Parliament as a result of us raising the basic pension in line with earnings - and this saving (a bizarre benefit of the Chancellor's means-test) will finance half the cost of the increase in the basic pension over the life of that Parliament. The other half of the cost will be met by ending most of the New Deal - which has been an expensive failure.
But some will say: "that is irresponsibly short-termist: what about the Parliament after next, and the one after that? Aren't we piling up huge liabilities by linking the pension to earnings? How will we meet these medium-term and long-term costs?"
The first point to make in response to this understandable but mistaken criticism is that it fails to recognise the liabilities that are in any event being piled up by the Chancellor. The medium term effect of the Chancellor's current policies will be to bring some seventy five per cent of pensioners on to means-tested benefits. If, on the contrary, we continue in future Parliaments to raise the Basic Pension in line with earnings, we will gradually lift more and more pensioners out of these means-tested benefits, making savings for the taxpayer which will partially offset the cost of the pension rises themselves, just as in the first Parliament.
The second point to make about the medium and long term responsibility and affordability of the policy is that we acknowledge we shall have to make some tough decisions in the second and subsequent Parliaments. For example, we need to look again at the existing contracted out national insurance rebates where the rules have become ever more complex and which are no longer actuarially fair. Roughly speaking, £11 billion of rebates are paid each year, but we are told by the industry that people have to give up rights to state second pensions worth about £12.5 billion in order to get them. Indeed, contracting out of the state second pension has been described last year in the pages of Pensions Management Institute News as "a mediocre deal that survives on inertia." Where inertia doesn't apply, such as in the brand new stakeholder pension market, over 80% of policies are not contracted out. There must be a better way of using £11 billion a year of public money to incentivise people to make provision for retirement - although, in making any change, we will of course need to protect rights that have already accrued to second state contributory pensions.
We will be consulting widely about the best ways in which to fund rises in the basic state pension beyond the first Parliament, and about the best way in which to create new incentives for saving once the disincentive provided by dependence on means-tested benefits in retirement has been eroded.
Provided that we have the will to make these tough decisions, and the courage and honesty to explain them openly to the public I am confident we can persuade even the most sceptical commentators that the policy is not short-termist or irresponsible or unfinanceable in the long-term.
But others of our critics will say: "even if the policy is costed and affordable in the first Parliament, and even if it is responsible and financeable in future Parliaments provided the right, tough decisions are made, is it not still merely and opportunistic populist attempt to buy pensioner votes?"
To this line of attack I reply: the policy so far from being opportunistic is derived from fundamental principle. It is derived, indeed, from the principles I have been enunciating in this speech.
The point of the policy is not to buy votes. It is to lift pensioners out of means-testing and, thereby, to restore the incentive to save, to reward saving.
That is a noble, a principled, and a truly Conservative purpose. It arises from a deep desire to foster the savings society that is currently being eroded by Mr Brown, with his means-tested dependency and his massive disincentives to save.
The point of the policy, in other words, is to enable us to build a better Britain.
A proper pension, unaffected by means-tests and which therefore gives no disincentive to save is the first pillar of a savings society.
But we need also to attend to savings before retirement if we are to avoid over-reliance on debt in the medium and long-term.
The second pillar of a savings society is a huge accumulation of private savings, for retirement and through life.
At the moment you get tax relief if you save for your pension. But that means you can't get at your money until you reach retirement. It's a one-way street into the fund with no means of getting your money out.
You also get tax relief on the investment return from an individual savings account, an ISA. You can withdraw that money freely, but once you've done that, it can't be replaced. You can't put that money back in. So it's a one-way street out.
This is a very inflexible system and I believe it deters some people from saving.
Wouldn't it be far better if you could save for the long term without having to pledge not to touch it until you reach retirement?
And if you did draw on your savings for a rainy day, wouldn't it be better if you could put the money back in later without penalty?
And wouldn't it be a real incentive to save if the Government put in a contribution alongside your own, available when you retire?
And wouldn't it be even better if once you had built up a fund, you were able to pass it on to your children as the basis of a fund of their own?
We believe there is a savings vehicle which can fulfil these ambitions. We call it a Lifetime Savings Account. Its aim is to enable everyone to build up their own personal pot of savings to draw on as they wish.
The LSA is designed as the long-term savings plan of choice for the starting and basic rate taxpayer.
· All contributions made by the saver receive a top-up from the Government in a separate escrow account. The saver will gain access to this top-up money at retirement to the extent that he has left money invested in the LSA, or withdrawn it and subsequently replaced it. At retirement, the savings in the LSA and those earned in the escrow account are available to the saver.
· It offers equivalent or better tax incentives than ISAs and individual pensions for these people and - crucially - easy access to their savings before retirement, with the ability to replace withdrawals at any time before retirement.
· The LSA is a straightforward, transparent and flexible product, building where appropriate on the positive features of its 'sister' products, the ISA and stakeholder pension.
· One of the key strengths of the LSA is the way that it complements its sister products rather than seeks to replace them. This is a crucial difference from the way such products have been introduced in the past, promoting greater continuity, better consumer understanding and easier adoption by the industry.
We will be consulting widely about how the Lifetime Savings Account will fit with existing products and the most effective way of providing Government support and, of course, about ways of meeting the cost of such support within the overall reform of the pensions regime.
I believe that these measures - the gradual and sustained raising of the basic state pension to the point where it lifts pensioners out of means-tested benefits and restores the incentive to save for retirement, together with the progressive enlargement of 'rainy-day' savings through a Lifetime Savings Account - can make a significant difference to the propensity to save in this country.
But underlying these specifics, lies the critical proposition that has been my principle purpose today to advance: the proposition that cautious optimism about the ability of the economy in the short-term to sustain high levels of household debt and low levels of household savings cannot be allowed to turn into complacency about the medium and long-term.
If we continue to move along the current trajectory it will take us away from a culture of savings and towards a culture of dependency. That trajectory is not sustainable. We need, over a generation, to change course.
We need, not overnight but gradually and sustainably, to begin again to make Britain a saving society, a society characterised by the prudence and independence of its citizens.
The three pillars
I'd like to leave you with this picture.
The strongest form in nature is the triangle.
And like a triangle, the Conservative vision for the personal finances of our nation is composed of three elements.
The first element is a property owning democracy; building on past success, we need to continue to spread home ownership throughout our society, acknowledging that this will continue to entail in a small and crowded Island relatively high mortgage borrowing during the early and middle parts of most people's adult lives.
The second element is a decent pension for all; whatever their circumstances, we need as a nation to ensure that, after a lifetime of work, people have a living income in their retirement through a basic state pension that rises in line with earnings and frees people from dependency on means-tested benefits.
The third element is the revival of our savings culture. Building on a basic state pension regime that frees people from the fear of means-testing, we need to help as many people as possible to accumulate financial assets. This third pillar is to be vastly enhanced by our lifetime savings account.
The stability of home ownership.
The security of a decent pension.
The sustainability of a savings culture through a lifetime savings account.
These are three strong pillars on which we can build a nation of savers.