'Rate cuts won't help people reduce debt'

HOUSEHOLD debts are now so high that even interest rate cuts will not help hundreds of thousands of people to get out of financial trouble.

That is the gloomy conclusion of one of the City's most respected economists, who claims the total burden of debts, including the interest and principal amount borrowed, is at its highest since 1989 - just before recession struck.

The 'buy now, pay later' culture created by low interest rates has encouraged people to go on shopping splurges with credit, rather than save up and buy goods when they can afford it.

In the 1980s, people became unable to service their debts because of a surprise spike in interest rates. But now, with rates at relatively low levels, it is the principal loan, rather than the interest repayment, that is proving the biggest burden. Faced with this looming crisis, the Bank of England's ability to cut interest rates is rendered almost powerless.

'Households have suffered from money illusion,' said ABN economist James Carrick. 'Though interest payments remain affordable, households are struggling to repay the debt principal in a low inflation world.'

ABN Amro argues that the Bank would rapidly have to slash the cost of borrowing by almost half - from the current 4.75% to 2.5% - for householders to allow people to start repaying their principal debt in any meaningful way. Even with the recent flurry of negative news on the economy, the Bank's monetary policy committee would never take such action.

The wider impact of consumers' 'money illusion' will be to hold back economic growth drastically. Not only are people having to rein in spending to service debts, they have also bought so many items such as refrigerators, TVs and other expensive goods that little in their homes now needs replacing.

ABN is not the only City institution worried about sky-high borrowing by consumers. The Bank of England yesterday urged High Street banks to share their information on customers applying for credit cards to prevent people taking on too many loans.

It cautioned that a 'significant proportion' of debtors borrow from more than one lender, so individual banks do not have a full picture of their, sometimes perilous, financial situations.

The Bank's Financial Stability Review warned the rapid growth in lending posed a potential long-term threat to economic stability.

A rise in personal insolvencies to levels 30% above their peak in the early 1990s was linked to the rise in household borrowing, it said.