COLUMN-Deleveraging takes hold in Britain: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

HUNTSVILLE, Alabama, September 3 (Reuters) - The British are doing what for them has traditionally been unthinkable - paying back debt - an individually smart move which in aggregate spells trouble.

Combine this with a banking system that has turned extremely conservative and you have the potential for an extended downturn or at best, a recovery that feels a bit like the period after a severe bout of the flu.

Since 1993 the Bank of England has been keeping tabs on the amount of debt carried by households and since then the British - who make their American cousins look positively frugal - have been consistently leveraging up.

Until July this year, that is, when figures reported by the Bank of England showed consumer debt, such as credit cards, was repaid to the tune of 217 million pounds, the most on record.

UK households paid back a net 418 million pounds of debt borrowed against houses, the most since, you guessed it, records began.

The explanation is pretty simple. After 15 years of borrowing and spending in a more or less benign job market and with asset prices rising, British consumers now face the opposite: 2.44 million seeking work and house prices that have fallen about 20 percent since the peak.

These facts have not escaped the notice of the banks, which have lost big in the downturn and are aware of both their own and their customers frailty. Despite massive material support from the government, and in the face or repeated tongue-lashings, the banks are not lending at a rate to inspire confidence.

How much of this is unwillingness and how much a lack of demand is unclear. What is likely is that if money does not move around the economy more rapidly there will be continued strong downward pressure on prices and asset values.

Speaking at a conference in Barcelona last week, Bank of England Monetary Policy Committee member Charles Bean was blunt about the risks.

"An open question is therefore whether the banking system will be able to support an adequate volume of credit as the extensive network of public support is removed," Bean said.

"If not, then further attempts to deleverage are possible. And deleveraging through the restriction of new loans generates a positive feedback loop analogous to that through asset sales", he said.

"De-leveraging by restricting credit growth may be privately rational, but if every intermediary tries to do the same, the result will be lower activity and higher defaults and little improvement in leverage ratios - what, to paraphrase Keynes, we might describe as the 'paradox of deleveraging'."

OPEN CAPITAL MARKETS A HELP

Among British businesses, the situation is pretty similar. Bank of England data showed that outstanding loans to companies not involved in finance fell by 8.4 billion pounds in July, a fall of 1.7 percent and the biggest since those records began in 1997.

The logic ruling the corporate loan market is similar. The prospects for profitable investment are scant and, from the bank's point of view, the need to bolster capital by extracting high marginal rates is urgent.

Corporations and consumers are of course creating their own self-reinforcing feedback loop, as spending cuts in one leads to spending cuts in another.

The situation for companies, at least the larger more creditworthy ones, is helped by the re-opening of the public capital markets this year.

This may have replaced some of the money that would otherwise have been raised via banks, and tellingly, a substantial amount of equity is being raised publicly along with debt.

In June for example, British companies raised a bit less than five billion pounds via the sale of bonds and commercial paper and about double that in equity. That is a sensible and encouraging start, but it is important to understand that reducing leverage in this way brings with it its own problems, not least for existing holders of equities.

Public debt markets are of little help to small and medium sized businesses, sadly, not to mention less creditworthy ones, and for them a tight-fisted banking system is a job and growth killer.

To judge by recent money supply data, which the Bank of England watches closely to measure the effectiveness of its program of quantitative easing, holdings rose only sluggishly outside of the financial sector. This reinforces the idea that the money being pumped into the banking system is to a distressing extent staying there, rather than working its way around the economy helping to keep prices from falling.

The net result doesn't have to be the end of the world, but its not likely to be as vibrant and expansive as the British have come to expect.

For the Bank of England, my guess is that they will expand and extend the programme of pumping money into the economy via quantitative easing. If not, there will be a sizable butchers bill.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on [SAFT/])