When will the bubble burst?

THE British public are borrowing, spending and consuming as if there is no tomorrow: house price increases are accelerating, mortgage advances are soaring and borrowing on plastic and via overdrafts continues to rise at spectacular rates.

All this is happening despite the Bank of England's best efforts to slow the process by raising interest rates twice since November.

We have become a nation - from the Government down - which is living on the nevernever.

Despite Chancellor Gordon Brown's optimism that the good times will keep rolling, such a view looks increasingly like a gravity-defying act.

For the history of all financial bubbles - and make no mistake, we are in the middle of one now - is that they end by bursting. In the process, many people can be hurt.

Even the most conservatively run economies, like that of Germany in the period after World War II, eventually hit a brick wall.

On the surface, certainly, it looks as if the British economy today is doing extraordinarily well. National wealth is expanding at or close to a rate of 3%.

According to the Chancellor's calculations, we are enjoying the longest sustained period of expansion for two centuries. Unemployment is at the lowest level for 50 years and the demon of inflation has been beaten.

Unfortunately, the truth is that this enviable record has been built on a debt mountain.

The Government's spending spree on public services is being paid for by public borrowing, which rose to £37bn last year and is unlikely to be any less in the current 2004/05 tax year.

Moreover, consumer credit is out of control and the nation is having to raise around £20bn a year to finance the balance of payments deficit on overseas trade.

As a result, we have an unbalanced recovery which is being jet-fuelled by official borrowing and consumption. Meanwhile, manufacturing, which is still the lifeblood of a productive nation, is struggling.

What makes matters worse is the Government's scandalous neglect of savers, which means that the proportion of national income put by for the future is almost half the level of all major industrial countries except America. All this has led Mervyn King, governor of the Bank of England, to express fears that unless house prices and consumption can be slowed, then the recovery of manufacturing and exports will be damaged because of the economy overheating.

He is not alone. In a recent searing report on the British economy, the influential Paris-based think-tank, the OECD noted that, while 'private consumption has been the prime driver of growth', it may also become a 'source of fragility'.

It also urged the Chancellor to slash the balance of payments deficit by raising taxes or cutting spending to reduce the need for future increases in interest rates.

If one wants to understand just how out of kilter the British economy is becoming, I suggest people take a look at the latest figures from the Bank of England, the guardian of monetary stability.

They make for alarming reading, coming as they do in the wake of two quarter-point interest rate increases in November and February which pushed base rates up to 4%.

The figures show that total lending in the economy in February climbed to £10.7bn, the third highest figure on record.

In particular, home loans are climbing at an explosive rate, having risen by 14.5% in February - the strongest figures since the Bank of England starting keeping such data a decade ago.

One key aspect to this lending surge is the fact that many homeowners are continuing to extract capital (the notional gains that they have made as a result of the rise in value of their properties) from their homes.

While some of this money is being reinvested in home improvements or invested in the buy-to-let market, much is being spent on luxury items such as cars, holidays and new clothes.

This is symptomatic of a society which places a value on instant gratification.

Given the pace at which credit is growing, it is now all but certain that the Bank of England's monetary policy committee, which sets base rates, will continue to raise interest rates until a perceptible slowing of house prices and lessening of borrowing occurs.

The latest figures show that the total household debt still outstanding has reached 125% of post-tax household income. This compares with just 90% in 1998, soon after Labour came to office.

At the moment, since interest rates are relatively low and the market for mortgage loans is so competitive, the cost of servicing such loans is relatively low at 7%.

But this tells only part of the story. In recent decades, high inflation has meant that the cost of repaying the initial loan shrank over time because the mortgage became less of a burden as wages rose very sharply.

However, that is no longer the case at a time when inflation remains at historically low levels and the loan hangs around the borrowers' necks like an anvil. Add to this the burden of rising interest charges and you have a combustible combination.

Only last week, Sir Andrew Large, deputy governor of the Bank of England, noted that if base interest rates were to increase by the end of the year in line with what the markets expect - to 5% or more - then the amount of money borrowed, relative to after-tax earnings, would climb 'towards the peak seen in 1990'.

New entrants to the housing market who are conditioned to think that rising prices and cheap mortgages are the norm, should take careful note.

In the early 1990s, more than a million homeowners suddenly found that the crashing value of their homes made them worth less than their mortgage.

This resulted in the dreaded phenomenon of 'negative equity.'

So, predictably, when the economic downturn happened, accompanied as it was by rising unemployment, tens of thousands of homeowners faced the bailiffs or were forced to return the keys of their homes to the building societies and banks.

Of course, no one is suggesting that millions of people could lose their homes this time.

The independent Bank of England has introduced a degree of stability and good sense into policy-making and is largely free from political influence.

Nevertheless, it still faces a delicate problem since the Government is doing nothing to calm borrowing.

On the contrary, it is pouring petrol on the fire by running its own large budget deficit - even if the nation's overall borrowing is still less than our major trading partners.

Eventually, the Bank will have no choice but to raise interest rates to rein in the consumer and borrowing.

The higher they rise, the more dramatic and shocking the correction will be.

In the meantime, we can only hope that the large majority of those who have been doing the borrowing will have not over extended themselves so that when the adjustment to house prices comes - as it inevitably will - it will not be too traumatic.