In the US, the bursting of the property bubble forced millions of homeowners into arrears, negative equity and foreclosure, dragging down consumer confidence and spending power in the process. The Obama administration responded with measures to help over a million of these homeowners deleverage by restructuring their mortgage debts. But the sheer scale of the loss of housing wealth and the drag anchor effect it is having on the US recovery has led economists of left and right to call for much more radical mass mortgage restructuring programmes, so that the process of deleveraging can be accelerated. This debate might soon travel across the Atlantic.

In the UK, emergency measures taken when the financial crisis first struck in 2008/09 – most notably in changes to court procedures, interest payment subsidies to those losing their jobs and forbearance from lenders – alongside record low interest rates have staved off mass repossessions. The housing market, which in contrast to those in the US, Ireland and Spain had been undersupplied with new homes, didn’t collapse.

Yet the household debt-to-GDP ratio in the UK is the highest of all the G7 countries, and as this chart from the Bank of England’s recent financial stability report shows, household debt relative to income is still higher in the UK than in the US and the eurozone. The stock of household debt remains at the same level as in 2008, at £1.5 trillion.

Figure 1: Household debt relative to income

In addition, households have been reducing their debt largely through nominal income growth, rather than actively paying down debt. Deleveraging is proceeding more slowly in the UK than in the US.

Figure 2: Contributions to change in debt-to-income ratios since 2008 Q3

This has led economists like Dean Baker – who, in contrast to most of his profession, spotted the US housing bubble and predicted it would burst – to argue that the UK (as well as Canada and Australia) still has a housing bubble. As Baker argues:

‘In the case of the UK, house sale prices increased more than 115 per cent in excess of inflation between 1996 and 2010. Over this period, rents pretty much kept even with the overall rate of inflation. In Australia, house prices rose by more than 80 per cent between the start of 2002 and end of 2009, a period in which rents rose by roughly 30 per cent. Canada has a similar story. The average house price in the UK is now almost 60 per cent higher than in the US. It had been 20 per cent lower in the mid-90s. In Canada, the average house price is more than 70 per cent higher than in the United States. The price of the median house in Australia is more than 225 per cent of the median house price in the United States.'

‘Given that wages in the United States are the same or higher than in all three countries, it is difficult to see how this huge gap in house prices can make sense. Furthermore, since rents have not notably outpaced inflation in any of these countries, it does not appear that the price increases are being driven by the fundamentals of the housing market. If there was a serious shortage of housing we should expect it to be showing up in rents as well. In short, there is good reason to believe that house prices in these countries will not be sustained anywhere near current levels. All three are likely to see the same sort of house price collapse that has wreaked so much havoc on the US economy. It’s impossible to know what the triggering event will be; a rise in interest rates could certainly deflate a bubble quickly.’

Optimists might retort that the UK housing market is in better shape than this account suggests. Arrears and repossessions have not been rising. Construction activity is down and house prices are flat or falling outside London, but rent rises suggest that asset values therefore reflect supply shortages, putting a floor under possible falls in prices. Interest rates look set to remain low for a while, given the stagnation in the economy, while the labour market is performing better than expected, holding up household finances. Forecasts for arrears and repossessions in 2012 might support that more benign view.

The Bank of England is less sanguine, however:

‘These aggregate data may, however, mask important distributional changes. For example, the 2011 NMG survey reported that since 2007 the proportion of borrowers reporting difficulties in keeping up with housing payments increased from 7.5% to 10% and the proportion finding unsecured debt a ‘heavy burden’ or ‘somewhat of a burden’ increased from 38% to 46%. This reflects a squeeze on real incomes and tighter credit supply. Despite evidence of repayment difficulties, however, write-offs on mortgage lending remain low, possibly reflecting forbearance by banks. The FSA’s recent review found that 5% to 8% of UK mortgages are subject to forbearance.’

A little-noticed paper by Angus Armstrong for the National Institute Economic Review in May this year adds grist to the mill of this disaggregated picture. It shows that loans to low income households rose, while consumption inequality didn’t, in the years running up to the crash – suggesting that those on stagnant real wages and low household incomes were leveraging in order to maintain their living standards and to access home ownership. On the eve of the financial crisis, there were 12,000 different mortgage products on the market, of which two-thirds were for credit-impaired borrowers.

This brings income inequality back into the picture and beneath it the structural problem of generating demand in an economy when workers don’t share in rising prosperity. In the short term, UK households need to deleverage more rapidly, which would be made much easier if fiscal policy played a supporting role in keeping aggregate demand up. As it stands, deleveraging will happen both more slowly and more painfully, once interest rates rise and forbearance is withdrawn.

In the medium term, however, the big question for the UK economy is how it can generate demand through high real wages rather than debt-financed consumption.

This post first appeared on Nick's blog.