The credit addiction

I think there's a major warning to Australia in what's happened the past few days in the UK.

After the initial flareup in Tottenham, most of the London riots happened in a quite distinct set of suburbs. Hackney, Peckham, Harringay, Clapham, Brixton, Kilburn, Lewisham, Ealing, Bow, Bethnal Green, Camberwell. I know all these places pretty well for a simple reason: they're where my friends live. My friends mostly being upwardly-mobile, middle-class thirtysomethings, this is another way of saying that violence has broken out wherever there's been a wave of gentrification in recent years.

My initial assumption was that most of the rioters were teenagers, but I've been struck by the anecdotal sense from the magistrates' courts yesterday that a lot were in their 20s to 40s, and not necessarily with any criminal background. If this is borne out, it strengthens the sense that a major current running through these events has been economic: people who feel shut out of some version of society, taking their revenge.

I've also been struck of late how many pretty mainstream financial world folk have been launching Jeremiads against governments' failure to act on the housing bubble of the noughties. Jeremy Grantham of GMO and Societe Generale's Albert Edwards have pretty well accused central banks of standing aside while the rich looted the poor through the medium of the housing market. I'm not exaggerating their language here.

I think the analysis gets motivation dead wrong, but in terms of consequences I think they're right. Restrictions on credit are some of the oldest human laws: some of the first scraps of writing from Mesopotamia refer to regulations on interest rates, and the Bible is full of regulations on usury and debt forgiveness. There's a reason for this: credit is an addictive substance that ordinary punters have trouble handling. Most of us have only the vaguest idea of how our earning and spending patterns are likely to change over a lifetime, and how unexpected events can change these ratios.

But in recent decades--the period of the "great moderation", when we appeared to have solved the economic woes that plagued previous generations--we have dropped those restrictions. It's easy to see how this happens. Go back 30-40 years and all sorts of aspects of consumer banking were very heavily regulated. Lobby groups push for a particular regulation to be dropped; the government drops it, cautiously at first. A few years go by and nothing untoward seems to have happened. So another regulation is lined up for the chop.

Each dropped regulation, in the absence of a consequent crisis, strengthens the notion that the regulations served no useful purpose in the first place. You end up in a world where, as Alan Greenspan once put it, you think that bankers' self-interests are enough to keep the system running safely. He laid out that theory in a Congressional hearing in late 2008. And in the same hearing, he admitted that it was clearly wrong.

I don't see particularly bad motives at work in that process. No one deliberately tries to drive their economy off a cliff (oh, except House Republicans...) But I see the action of that old Keynes maxim: It is difficult to get someone to understand something if his livelihood depends on his not understanding it. The fact that nothing has gone wrong yet becomes an impregnable argument against the suggestion that anything could go wrong ever, especially if everyone fears the consequences of taking away the punchbowl when the party is in full swing. So you end up with the situation you have in Australia, where lenders see nothing disturbing in creating property millionaires, using mortgages that will keep the millionaire borrowers living below the poverty line in terms of their free cash.

Loose credit policies only benefit two groups of people: lenders and asset owners. Asset owners see the value of their assets rise faster than inflation or incomes, as looser debt allows potential buyers to commit more and more of their incomes to the purchase. Lenders see people taking out bigger loans, increasing the returns available on the same stock of assets. Everyone else is doomed by the fallacy of composition: you may think that looser credit allows you to buy more stuff, but everyone else thinks the same thing and, in the case of supply-constrained assets like housing, the result is just that prices rise to match the increased supply of credit.

As far as housing in concerned, you now have a generation of the middle class who are locked either into cripplingly high mortgage payments if they buy property without substantial aid from their families, or locked out of property ownership altogether. Tenants are still exposed to the situation, however, because the collapse of government house-building programmes leaves most of them to the mercies of over-leveraged buy-to-letters. Add in the reform of housing benefits, which will sharply jack up housing costs for poorer Londoners, and you have a toxic mix.

I think it's true that these trends tend to correct eventually. Housing costs cannot always remain so far ahead of their long-run ratios to incomes. But in housing, those trends are extraordinarily long, so whole generations can be locked into paying too much.

Kate and I are relatively insulated from this because we've got relatively high incomes and an aversion to debt. That we don't own property is more about choice than capacity. But when most people of my generation look at those even 10 years older, they see people on similar incomes with property wealth that they will literally never hope to attain in their lives. They're then told that they will have to work longer, and save harder, and pay more, and take on still more debt, to preserve benefits enjoyed by older generations that they themselves can never be expected to receive.

As I can't say enough, none of this excuses the violence, thuggishness and vandalism that has happened over the past week. But social unrest, however apparently apolitical, is almost always fuelled by some deep-seated sense of injustice. And I think you see it right there.

In the UK at least, this particular bubble pretty well burst with Northern Rock late in 2007. Tighter credit standards and falling house prices have reversed the trend since then--although, again, it's telling that the riots broke out in the one part of the country where house prices have been rising again. But in Australia, the boom has mostly continued, and even accelerated, since then. That doesn't bode well for what will happen when this economy eventually runs into hard times.