US ahead of UK on road to reducing debts

The consultants McKinsey has returned to one of the business and economic issues of our age, the massive debts of the rich developed countries that borrowed excessively to fuel growth in the boom years.

In a new paper, with the racy title Debt and Deleveraging: uneven progress on the path to growth, McKinsey asserts that the task of reducing the indebtedness of consumer-led economies such as the UK and Spain is barely underway (and see my earlier post, UK's debts biggest in the world, for more on this).

McKinsey makes the striking claim that "the ratio of UK household debt to disposable income would not return to its pre-bubble trend for up to a decade" - which implies that as we in the UK look for a return to more normal levels of economic growth, momentum is not going to be provided by consumer spending for perhaps up to 10 years.

And looking at the 10 largest developed economies, its analysis is that only three of them have seen a fall in indebtedness or "leverage" since the crash and recession of 2008.

McKinsey adds together the debts of companies, households, government and financial businesses to arrive at a figure for the overall indebtedness of an economy, which it then relates to the output of the said economy or GDP.

On this measure, the aggregate indebtedness of the UK has risen from an already large and arguably unsustainable 487% of GDP in the second quarter of 2008 to an even bigger 507% of GDP in the middle of 2011.

Only Japan, hobbled by its debts for 20 years, is more indebted - with a debt to GDP ratio of 512%. I guess there is small comfort in this, because as I noted in the autumn, in the first quarter of 2011 the UK was a little more indebted than Japan.

What is striking is that there has been modest reductions in the indebtedness of British households and non-financial companies over the past three years, to 98% and 109% of GDP respectively - which are still high levels of leverage or high debt ratios by historic standards.

But all that slowish progress in cutting debts to more bearable levels has been more than offset - McKinsey says - by a 28 percentage point rise in government indebtedness to 81% of GDP and an 11 percentage point rise in the indebtedness of financial institutions (the City) to 219% of GDP.

Now there is a bit of an argument about the significance of the financial institution debt, about how much of it is genuinely a risk or potentially deadening weight for the British economy. But even putting that to one side, the rising indebtedness of the state more than offsets any progress by the private sector in reducing debts.

Which is why McKinsey argues that the UK is still at a very early stage in reducing debts sufficiently to allow a significant rebound in economic growth (as you will have read here many times, growth tends to remain insipid or worse, while businesses and households repay what they owe - either by choice or by order - because they invest and spend less).

Now to give more of a clue to how and when our economy will recover, McKinsey has looked at the experience of two Scandinavian countries, Sweden and Finland, which experienced credit and housing booms (rather like us) in the 1980s that turned into an economic and financial bust in 1990 (sound familiar).

Both Sweden and Finland returned to fairly robust growth in a matter of a few years, on the back of six phases of recovery. So McKinsey has looked at what it calls these six "markers" of recovery to assess how early or late in the rehabilitation process the UK, Spain and the US are.

So what are the six stepping stones to a resumption of economic health? Here they are:

1) A stabilisation of the financial sector, with lending volumes rising. On that measure, the US is ahead of the UK, which is ahead of Spain.

2) Structural reforms have been implemented to make the economy more competitive. There has been a good deal of talk about such reforms in the UK and Spain (for example planning reforms in Britain), though not a great deal of action yet.

3) Credible medium-term public deficit reduction plans are in place. Well many would argue that's truer of the UK than it is for the US, where the political rows continue about reducing the deficit. As for Spain, its austerity measures are work in progress.

4) Exports are growing. Well exports have been rising in the UK, but not enough to offset weakness in other parts of the economy.

5) Private investment has resumed. This is the big concern in the UK, that big companies are hoarding record amounts of cash rather than investing, and smaller companies lack the finance from banks to invest.

6) The housing market is stabilised and residential construction revives. Well there's no sign of that in Spain. In the UK, house prices seem to have stabilised, but McKinsey would argue there is grossly inadequate housebuilding. And in the US, the housing market still seems fairly weak.

McKinsey argues that the US is furthest ahead in the deleveraging or debt-reduction process, with its ratio of aggregate debt to GDP having fallen 16 percentage points to 279% since 2008. What's most striking in the US is that a fall in private sector indebtedness has significantly exceeded an increase in government borrowing - with household debt actually falling in absolute terms (in large part because of write-offs of housing debt).

What may seem odd is that the US advantage appears to reside, to an extent, in the way that householders peremptorily walked away from their unaffordable mortgages and handed back the keys to their respective properties or were evicted from their homes by banks - forcing the banks and other lenders to incur big upfront losses. Banks and citizens took a big early hit and then moved fast to restore their finances.

From the outside, it may all have seemed a bit brutal. But arguably these mortgage writeoffs have facilitated an earlier restoration of the confidence of banks and consumers.

In the UK, by contrast, banks behaved in what would be seen as a socially responsible way, by allowing homeowners with mortgages they can't afford to cease interest payments for a period (banks exercised what's known as "forbearance").

The problem with easing the pain for those with big housing debts in this way is that neither bank nor borrower recovers properly: banks don't properly recognise the losses they are likely to one day incur on the mortgage; homeowners are still burdened by an excessive debt.

So McKinsey contrasts the 14% of British mortgages either in forbearance or explicitly delinquent with a very similar proportion in the US that have been written off or are in the process of being written off. And the implication of that is that there is much more pain to come for banks and those with excessive mortgages in Britain.

Which is another of the manifold reasons why economic growth in the UK is likely to remain lacklustre for years.

As for Spain, its problems reside in a corporate sector with bigger debts, equivalent to 134% of GDP, an extraordinary housing boom that over 10 years created five million new homes in a country of just 14 million households, and a banking sector that is yet to recognise all the losses it will incur on property and business loans.

And you don't need telling that its problems are currently massively compounded by its membership of the eurozone - which shackles it with an uncompetitive exchange rate, punitive interest rates on government debt, and no lender of last resort to fill the breach if investors decide to boycott lending to the state.

Which is why, broadly, and on McKinsey's analysis, it would seem that in the vital process of getting debts down and putting the economy on a sustainable financial footing, the US is ahead of the UK, which has an important advantage over Spain.