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Could the Debt Crisis be leading us to a new financial crisis?
 

Could the Debt Crisis be leading us to a new financial crisis?

 

This week, the new Head of the Business Select Committee, Rachel Reeves MP, an economist who worked at HBOS during the 2008 financial crisis, said debt problems similar to those in the run up to the financial crisis are ‘rearing their heads’.

This follows a number of warnings on debt that the Bank of England has given this summer. Three days ago, the Bank of England’s financial stability director, Alex Brazier, warned about the ‘dangerous’ levels of personal debt during a speech at the University of Liverpool’s Institute for Risk and Uncertainty.

Personal loans have increased 10% over the past year, and the Bank of England estimates that the country’s total personal debt is around £1.5 trillion. Car loans are particularly notable and Brazier warned that High Street banks were at risk of ‘a spiral of complacency’.

But does all this indicate a looming financial crisis caused by the Debt Crisis? Or is the issue more complex than that?

The Role of Debt in 2008

When Reeves spoke about debt problems in 2008 she was referring to the initial cause of the Financial Crisis in 2008 – subprime mortgages. Essentially, a huge number of people in the USA were offered mortgages when they shouldn’t have been.

When it became clear that they couldn’t pay them back, the owners of their debt made a loss. It is fairly normal, and financially healthy, for some loans to not be fully paid off as they are written off as part of debt settlement schemes, such as IVAs and Trust Deeds.

But by likening this situation to our current debt crisis, Reeves is suggesting that an excessive number of loans currently being given out by High Street Banks may never be fully paid back.

There is some evidence to support this idea. The average household debt as a proportion of household income rose from 95% in 1997 to 160% before the financial crisis. It had since fallen back to £140, but has now begun to grow again.

The Office for Budget Responsibility predicts that it will reach 153% by 2022.

Making a Financial Crisis

It is important to note, however, that subprime mortgages were simply the trigger of the crisis.

The severity of this crisis happened because of a ‘cascade’ effect, sometimes likened to a contagion, as the institutions who owned the unpaid debts were in turn not able to pay their own debts and caused a ripple effect across the entire western financial system.

As such, it is more important to look at who owns the debt – had financial institutions been able to withstand their losses, the situation could have been contained.

Therefore, it can be argued that the debt crisis alone is not enough to create a financial crisis. Financial Institutions have to be considerably unprepared and have poor practices to allow the cascade effect to take hold once again.

As Reeves, herself, said ‘we’re not going to have the same crisis in 2008’.

Martin Lowy, a former banker and now banking lawyer, believes that debt owners and financial institutions have learnt from 2008. Most of the large risk taking securities firms that were not able to withstand the crisis and caused the cascade effect have now been absorbed or disappeared.

Generally, global financial practices have improved. Notably for the UK, for example, the Bank of England has recently told banks to strengthen their finances against the risk of ‘bad loans’ as a measure against the debt crisis.

They were instructed to set aside £11.4 billion in the next 18 months to prepare for any future economic shocks that could happen were borrows to become unable to keep up with their repayments.

Ultimately, as Mark Carney, Governor of the Bank of England, noted in June; although some High Street lenders appear to have forgotten some of the lessons learnt in 2008, the UK financial system is currently far stronger than it was in 2008-9

Difference between a financial crisis and recession

It is important to note, however, that there is financial crises and recessions are very different things. A recession is simply a period of economic decline when GDP falls in two successive economic quarters and it can happen independent of a financial crisis.

Although ‘The Great Recession’ of the late 2000s to early 2010s was caused by the 2008 financial crisis, the next recession may not necessarily be caused by a financial crisis, but debt will play a similar, and important, role.

A significant aspect which prolongs a recession is the public’s unwillingness, or inability, to spend. Spending money promotes growth, which will increase the GDP and end a recession.

One of the worst aspects of the Great Recession was the role debt played in preventing that necessary spending and, unfortunately, it is widely believed that the ongoing debt crisis will have a similar, if not worse, effect.

If the debt crisis is not dealt with through helping people out of debt, then it is likely that the high debt burden will lower growth and slow recovery. This could lead to a cascade effect on global standards of living.

So, is the debt crisis leading us into a financial crisis?

No. This is largely speculative, and no prediction of the future is perfect, but it is not likely that the next financial crisis will be due to the debt crisis. Although it is true that a similar circumstance caused the financial crisis almost ten years ago, significant changes have been made to financial institutions to cushion the blow the debt crisis could have.

The debt crisis could make our next recession particularly bad, however. Luckily, there are plenty of debt solutions such and IVA’s and Trust Deed’s available to suit different circumstances which could help you out of debt and more financially strong in the face of whatever the future may hold.

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