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Economists’ blind spot to Britain’s biggest danger

Following the referendum vote to leave the European Union, the Bank of England Financial Policy Committee has highlighted the biggest dangers to the UK economy.  These include the potential for a crash in commercial property, the growing current account (balance of payments) deficit, fragile markets and problems in the wider global economy.

The biggest threat to the UK economy, however, is one that most economists do not even believe to be real.  According to Szu Ping Chan in the Telegraph, private debt is at the top of the list:

“While household debt has come down from its pre-crisis peak of 150pc of disposable income to around 132pc in the first quarter of 2016, the Bank warned that ratios remained ‘high by historical and international standards’.”

The majority of economists – especially those that advise governments – do not believe that private debt is a problem.  This is because they believe in the “loanable funds” model that claims that every Pound borrowed in the economy must have been loaned by a saver somewhere else in the system.  In fact, the Bank of England has led the way in debunking this belief; pointing out that almost all of the money now in existence was created by banks when they make loans.

The implication of this difference of view is crucial to what happens next.  In the loanable funds model, the risk is to those savers foolish enough to lend money to people who may not be able to repay it.  Government will insure the first £75,000 of any such losses, but above that and savers must take the hit.  The problem is, as critical economists like Steve Keen and, indeed, Bank of England economists themselves have pointed out, loanable funds is nonsense – the reality is that money is borrowed into existence every time someone takes out a loan.  The value of the loan is then added as an asset on the bank’s balance sheet.

Were this all that happened, it would be a problem, but not a huge one.  The problem is that banks sell these “assets” on to other investors, who create derivatives from them and sell them on again and again.  The money made in these transactions then tends to make its way into asset speculation; inflating bubbles in such things as London property, US auto-loans, student debt, fine art and hydraulic fracturing.  These bubbles, in turn, provide the growth and additional liquidity that allows the rest of us to continue working and consuming and – crucially – servicing our debts.

According to Chan, the Bank of England:

“warned that the ‘ability of some households to service their debts would be materially affected in the event of weaker unemployment and income growth’.  In other words: elevated levels of household debt aren’t necessarily a problem on their own. It becomes a problem when people start losing their jobs.”

The Brexit vote, rising energy costs, a US recession or a crash in China each has the potential to trigger exactly those job losses that will destabalise the system.  And this time around, things could be a lot worse than in 2008.  With interest rates already down to 0.5 percent, there is little more that the Bank of England can do to help households service their debts in the event of another recession.  In many ways the economic dominoes are lined up in much the same way as they were on the eve of the global financial crash in 2008.  The difference is that when they begin to fall this time around, we may well find that the “too big to fail” banks have become too big to save.

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