Debt is a double-edged sword: In contractionary periods it becomes a 4 letter word

Debt can be good or bad. It depends both on the reason for the debt, and the time wherein such debt is incurred.

(You may use credit as an interchangeable synonym for 'debt,' for purposed of this post, if you so choose)

It increasingly appears that much of the debt taken on by consumers, especially, during the last 5 years in the U.S. and U.K. may turn out to be toxic, and in fact, a malignancy that could possibly spill over and spread to even innocent actors, such as the businesses that have largely cleaned up their balance sheets, and even those that have kept away from debt and utilizing the vast pools of credit enticingly offered up to them by lenders.

During such periods, as people confront their indebtedness, either because they can no longer leverage assets for additional credit, and have to reign in their spending to keep those assets, or because they literally run out of money, and those assets are seized, the money circulation tends to slow dramatically, and if it begins to shrink, recessions occur.

The degree to which money circulation shrinks determines the depth and duration of the recession (or depression).




DEBT-GORGED BRITISH START TO WORRY THAT THE PARTY IS ENDING



Luke Wolagiewicz for The New York Times

British consumers went on a debt-financed spending spree and some of the borrowers are finding it difficult to pay their bills.

By JULIA WERDIGIER
Published: March 22, 2008

LONDON — At one point, Alexis Hall had more than 50 pairs of designer shoes and handbags. It never occurred to the 39-year-old media relations executive from Glasgow that her £31,500 in debt ($63,000) would be a problem.



Jason Butler of Bloomsbury Financial Planning says loans were too easy to take out.

“It was so easy to get the loans and the credit that you almost think the goods are a gift from the shop,” she said. “You don’t fully realize that it’s real money you are spending until you actually sit down and consolidate your bills and then it’s a shock.”

As the United States economy weakens, many Americans are being overwhelmed by personal debt, but Britons are even more profligate. For most of the last decade, consumers here went on a debt-financed spending spree that made them the most indebted rich nation in the world, racking up a record £1.4 trillion in debt ($2.8 trillion) — more than the country’s gross domestic product.

By comparison, personal debt in the United States is $13.8 trillion, including mortgage debt, slightly less than the country’s $14 trillion G.D.P.

And while the Federal Reserve in Washington has cut interest rates, in an effort to loosen lenders’ grip on credit, the Bank of England’s interest rate increases last year are trickling through to mortgages at the very time home values are dropping and banks are becoming more reluctant to lend.

Until now, debt has mostly been a good thing for Britain. In the hands of free-spending consumers, it fueled economic growth. The government borrowed heavily in recent years to invest in infrastructure, health and education, creating a virtuous cycle: government spending led to job creation, which led to greater consumer confidence and more spending, which, in turn, stimulated growth.

Economists say Britain’s relationship to debt is complex, but at its core is a phenomenon more akin to recent American history than European trends. As in the United States, a decade-long housing boom and strong economic growth bolstered consumer confidence, creating a perception of wealth almost unknown in countries like Germany and Italy.

“Culturally, maybe also because of the defeat in the war, Germans remain reluctant to borrow and banks are often state-owned, pushing less for profits from lending,” said Alistair Milne, a professor at Cass Business School in London.

Since many younger Britons have never lived through a period of slow growth, few now see the need to hold back on borrowing, not to mention saving.

“The general mantra is spend now, think later,” said Jason Butler, an adviser at Bloomsbury Financial Planning. “It’s easier to get a loan or a credit card these days than to get a savings product.”

The average British adult has 2.8 credit or debit cards, more than any other country in Europe. A growing number are borrowing to pay for vacations, furniture, even plastic surgery. As a result, Britons are spending more than they earn, racking up a household debt-to-income ratio of 1.62 compared with 1.42 in the United States and 1.09 in Germany.

To her parent’s generation, Ms. Hall said, owing money beyond a mortgage was “shameful,” an admission of living beyond one’s means. Debt was also more difficult to get.

That changed in the late 1990s when American lenders, including Citigroup and CapitalOne, pushed into the British market with a panoply of new lending products. Fierce competition among banks meant potential borrowers were suddenly bombarded with advertising and offers for low- or no-interest loans and credit cards.

While Britain’s financial regulators watched the explosion of retail lending from the sidelines, their counterparts in Germany and France were more restrictive. As a result, the British market became the largest and most sophisticated in Europe.

The growth was also fueled by soaring demand for debt on the back of rising real estate prices and relatively low interest rates in the late 1990s and early 2000s. Those who did not own a house rushed to join the homeowners watching their property triple in value.

The trend on the Continent was the opposite. Home prices in most European countries barely moved, mainly because markets were more regulated, there was more housing stock and renting was more popular.


James Falla of Thomas Charles says consumers had a false sense of security.

Liz Bingham, head of restructuring at Ernst & Young in London, blames the obsession with homeownership on Britain’s “island mentality”: land is seen as a finite good and a valuable asset.

“The housing boom automatically made people feel richer than they actually were and people went on to use the equity locked up in their property almost as a bank account they can dip into every time they want to buy a new car,” Ms. Bingham said.

As the perception of wealth grew, the social stigma around debt disappeared. Borrowing became such an accepted part of life that today one in five teenagers does not consider being in debt to be a bad thing, a survey by Nationwide Building Society showed.

Debt levels increased further as it became easier to get loans, and retailers, like computer chain PC World, offered both goods and the loans to buy them. Consumers happily accepted, thinking that as long as they were deemed creditworthy, they were not in danger of defaulting.

Andy Davie is a case in point. Even after he had racked up £70,000 in personal debt trying to keep his fruit and vegetable business afloat, credit card issuers kept increasing his credit limits.

“You tend to use credit to pay for credit and as far as the banks are concerned you are fine,” said Mr. Davie, 41.

He was finally forced to declare bankruptcy. Though still painful, the process made the prospect of defaulting slightly less daunting.

“Rather than showing up at court you just fill in an online form and speak to someone on the phone,” said Mark Sands, director of personal insolvency at KPMG in London.

The ease of the bankruptcy process, the availability of debt, the property boom and strong economic growth, lulled consumers into a “false sense of security that is now coming to haunt us,” said James Falla, a debt adviser at London-based Thomas Charles.

“It’s all good as long as the economy is doing well, but if that changes people will really get caught short,” he added.

And things are changing. Growth has already started to slow this year, and the government lowered its 2008 forecast to 1.75 percent to 2.25 percent, after 3.1 percent growth last year.

Home prices are falling, despite a dearth of housing and an influx of wealthy Middle Easteners and Russians, especially in London. Last year, housing foreclosures reached the highest level since 1999 and are expected to rise still further this year.

And more than one million homeowners have adjustable-rate mortgages that are expected to reset in the next 12 months — to significantly higher rates.

The prospect of rising costs has already prompted some consumers to change their spending habits. The camera retailer Jessops and the fashion store French Connection are among retailers feeling the squeeze and reporting lower sales since the end of 2007.

But changing spending habits will not be enough to solve the problem of rising debt levels, said Mr. Butler, the debt adviser. Consumers will also have to learn to save.

According to a survey for the Office of National Statistics, less than half the population saves regularly, and more than 39 percent said they would rather enjoy a good standard of living today than save for retirement. Ms. Hall said she was among that 39 percent. She recently took out new loans, planning to repay her existing debt. But she ended up spending the money on more luxury goods instead.

This year, she published a book about her experiences. She said she did not expect the book’s proceeds to repay her debts, but it may help the growing number of people in similar positions cope with theirs.

 

During times of parabolic rise in the value of specific assets (Shiller points to housing as the biggest asset bubble in the history of humanity), if debt is leveraged to those assets in even a remotely proportionate fashion (e.g. $1 of debt to each $25 or $50 of appreciation), and then the value of that asset begins to fall (especially where the asset is not 'free and clear', and is also, in and of itself, a net liability), the risk of a severe 'snap back' conflation of consumer spending increases dramatically.




This is likely to be one of those times. As housing values continue to decline in the U.S., and now, the U.K., the largest engine of consumer fueled business expansion (i.e. the most debt-laden consumers in the world, in the U.S. and U.K.) is likely to slow, and possibly retract (maybe severely)