Hamish McRae: Till debt us do part? Rate rises will test our ability to live with credit

Credit and debt. They are the same thing of course but one is the nice word and the other the nasty one. The fact that Britons have per head double the debt of Continental Europeans could be attributed to our fecklessness but it is also a function of the quality of our credit system.

The newspapers and airwaves have been full of stories about UK debt levels but just as they emerged, the efficiency of our financial markets was ranked as the best in the world by the World Economic Forum's global competitiveness report - the country as a whole came tenth. Britons borrow because it is much easier to do so than it is for most Continental Europeans: the spread on mortgages is lower and the terms are less onerous, while personal loans and credit cards are easier to obtain.

If the efficiency of our credit machine is measurable, what about our supposed fecklessness? What about the interplay between the two? And, most pertinently, what would happen were our burden of debt to be stress-tested by a significant rise in interest rates?

The "fecklessness" charge is an interesting one. People are free agents, able to choose whether to borrow or not, and the great majority of borrowers do not get into trouble.

Rationally, it has for most of the post-war period been the right thing to do to borrow to buy property. A very small proportion of homeowners have actually lost money on property investment: people who were unable to keep up their mortgage payments in the early 1990s and lost their homes. That was utterly miserable for them and was the result of the UK having to adjust its interest rates to fit in with sterling's membership of the ERM: we had to have rates that were too high for Britain. But that is over now. Provided people managed to maintain their ownership - even those who bought at the wrong time or overpaid - they have eventually been rescued by the general rise in property prices.

But if mortgage debt is almost unequivocally "good", what about consumer debt? Interest rates are higher, the assets decline in value. It is hard to defend as a financial strategy, though of course it does enable people to get things they need earlier than they would otherwise be able to do so. And there is a moral issue here: what right does a society have to try and deny people access to credit just because they are using it to increase their consumption?

It is worth making the distinction, though, because in the past couple of years something very interesting has been happening to British borrowing habits. We have kept on borrowing for homes but we have become much more chary about borrowing for consumer goods. You can see this in the top two graphs. Overall debt relative to income took off around 2001 but over the past couple of years the rate of increase of consumer debt has fallen sharply.

As a general rule, people borrow about the same amount as their income: more when we buy our first homes, then gradually less as we get older. But over the past five years, that ratio has soared: we now on average have borrowing equivalent to one-and-a-half times our income. Why?

I have not seen any really satisfactory explanation and it is probably too soon to know but I can see bits of the answer. One is the macroeconomic point that real interest rates were relatively low by historic standards as the Bank of England (and, to an even greater extent, other central banks) cut rates to try to pull the world economy out of the 2001 recession. True, we did not cut rates quite as much as other countries but we had a larger fiscal boost as Gordon Brown moved from running a surplus to running a large deficit.

Another part of the explanation is connected to low interest rates: the housing boom. That was both the creation of low rates (because it reduced the burden of servicing the debt) but also the justification for further borrowing because rising prices made getting into debt a sensible financial decision.

Finally we have had security of employment: along with sustained growth has come a sustained large expansion of the job market. This has underpinned people's confidence in borrowing - that they can if necessary earn their way out of trouble.

So why has the consumer debt come back? Here I think it is largely the impact of higher interest rates. Remember the stock of debt is still growing; it is simply growing at a slower rate. But I suspect that as rates go up further there will be more of a scramble to clear consumer debt, particularly as the institutions offering mortgages see this as a growth market. A lot of people may simply be paying off credit cards by increasing their mortgages, which carries the risk of losing one's home but since the interest rate is much lower, reduces the monthly servicing bill.

There is, however, another factor at work: the fact that real post-tax incomes have stopped rising, as the bottom graph shows. While we were getting richer, we did not mind borrowing more. Now we are not, or at least not much, maybe we are tending to be a bit more careful. As rising taxes and the sharp increase in the price of essential items such as fuel bites into our monthly budgets, we realise that it is not a great idea to run up further debts.

Or at least that is the best explanation I can manage. I think there is an attitudinal shift taking place towards what might be called frivolous borrowing. There has been a problem of the interaction between the credit providers, who should carry some of the blame for showering credit on people, particularly the young, and the slightly happy-go-lucky "I want it now" consumerism of the late 1990s and early 2000s.

We have over the past couple of decades gone from a world where it was quite hard for lowish-earners to get easy credit to one where it is easy and it has taken a while for attitudes to catch up with these extended opportunities. But we are catching up now.

Are we adjusting in time for the next "stress-test"?

Um. Well, that depends on the pace and duration of the coming rise in rates, what happens to growth and the labour market and how well the financial institutions manage their way through what will be a worsening debt situation.

We are not going back to very high rates. In this age of low inflation, the absolute ceiling on short-term rates will, I think, be what was during the 19th and the first half of the 20th century the crisis rate: 7 per cent.

But that would hurt a lot. Growth? It is OK now and will be for the next 18 months, maybe longer. Jobs? The upward creep of unemployment may continue through next year. While it is hard to see it really hitting damaging levels, for some individuals times will indeed be tough. And managing the debt mountain? I hope that the financial institutions will do better than they did in the early 1990s when they requisitioned a lot of houses unnecessarily.

My guess is that unless house prices really bomb there is not an overall macroeconomic debt crisis hanging over us. But there is a crisis for some individual borrowers and that needs to be tacked sensitively and determinedly in the months ahead.