The Credit Extended to the Private Sector - Essay Example

The credit extended to the private sector is defined as the total lending to households and private businesses to implement business transactions. Credit to the household sector consists of consumer credit and mortgage credit. Consumer credit constitutes loans granted for a specific purpose and credit granted for a general use (Balaguy, 1996). Credit to the households is covered by a contractual obligation to use the loan for the acquisition of a specific product and service. In addition, credit instruments cover an agreement whereby the borrower obtains funds from the lender, without any commitment as regards the goods or services to be financed. (Guardia, 2000). Consumer credit does not need a guarantee and the tax provisions covering this type of lending differ from those pertinent to mortgage credit. The circular flow diagram is very helpful in understanding Britain’s consumer debt. The circular flow diagram enables one to understand macroeconomics. Goods and services and resources flow through the economy in one direction. The money flows through the economy in the opposite direction. Money is exchanged for specific goods and services which the households purchase regularly. Another important aspect of the circular flow is the presence of the three main factors of production in the economy fall under these categories: labor, land, and capital. Wages reflect the price of labor. Rent reflects the price of land. Profit is the price for capital. Businesses in the economy are expected to generate profits. Workers who work in these businesses are paid in wages. Then the persons who utilize land for their businesses pay a fixed rent. The circular flow shows that the households (composed of family members), in the circular flow, own all the labor, land and capital. In markets for factors of production, households sell the services of labor, land and capital to firms in exchange for wages, rent and profit. Then in the area of consumer credit, the households borrow from banks (which hold or maintain the savings from the firms households and offer a credit service to the firms and the households ) in order to purchase at a current time a product or service that they need now. For the credit service, the banks then charge interest rates on the households for those loans. Then after a designated period of repayment, the households pay the loans plus the interest charges from the wages they derive from the sale of their labor services to the firms and the profits they derived from their businesses in the economy. (See Figure 1: Circular Flow Diagram). Then the households spend their income on products and services that are produced by firms. The money spent on goods and services is called spending (by households) and income (by firms), but spending and income are of the same number. In effect, the households (family members) have two specific functions in the economy. First, they sell their labor, land and capital to firms in order to make income, and second, they spend their income on the goods and services that firms produce. Similarly, firms or companies also play two important roles in the economy. First, they purchase the services of labor, land and capital, and second, they use labor, land and capital to produce goods and services, which they sell to households. Technology enters the circular flow diagram as shown by a firms ability to transform labor, land and capital into goods and services. When firms can generate more goods and services compared to the previous period while using the same level of labor, land and capital, then, the economists contend that the technology has improved. Figure 1: Circular Flow Diagram Comparison of British and German consumer credit Consumer spending in the UK was fueled by economic growth, consistent prosperity, low interest rates, low inflation rates, record employment figures and healthy fiscal revenues by the UK government. However, a new trend has emerged. UK consumers are beginning to get higher levels of consumer credit. The UK consumer market has these credit instruments: secured lending, credit unions, credit cards, store cards, and mail order. The UK is now targeting rouge lenders who are damaging the credit system by providing misleading information and unfair acts thus victimizing the unsuspecting consumers. For example, UK Parliament Member and Secretary Patricia Hewitt has proposed these new measures to address the problem: establish an independent ombudsman service to allow the consumers to question agreements; set an unfair credit relationships test to let consumers test unfair lending rates, practices and terms; include a santcion for lenders to give consumers better information about their credit status; and install improved powers for the Office of Fair Trading (OFT) to punish rogue credit companies with the end view of levying heavy financial penalties whenever applicable. (Hewitt, 2003). As a whole, there is a very low level of cross-border consumer credit transactions in the European Union as shown by the different regulations that apply to consumer markets, i.e., legal barriers. ( Launaloo and Almudena, 2004). The UK consumer credit market is undergoing a period of crisis in 2008. The UK would have to channel one-sixth of all its goods and services produced in one year to pay off its outstanding consumer debt. Chancellor George Osborne of the UK Parliament had pushed for restrictions on Individual Voluntary Arrangements (IVAs), which are the UK equivalent of the U.S. Chapter 13 bankruptcy filings. He also suggested lessons on money-management for 11- to 18-year olds. Osborne proposed that there be a seven-day cooling off period on the use of the retail cards. Hence, this entails that a consumer would be prohibited from using a new retail card for seven days after issuance. The UK credit market and the German credit market are markedly different. Moreover, the UK consumer credit market represents a very high level of 25% of the Gross Domestic Product in 2005. The UK consumer credit market represents 16% of the Gross Domestic Product in the year 2000. However, in 2001, the UK registered a huge drop in Net Lending for Consumer Credit by banks and consumer credit companies from 16 billion pounds to 13 billion pounds. (See Figure 2: UK Net Lending for Consumer Credit). If adjusted for inflation and set in dollars, the UK had a per capita consumer debt of $1,695 in 1993. In contrast, the German consumer credit market only accounts for 14% of GDP as of 2000. (Jentzsch, 2003). In 2005, the consumer credit market in Germany increased further and accounted for more than fifteen percent (15.7%) of the GDP. Germany cannot continue relying on increased household spending to attain economic growth in the coming years. Instead, Germany must rely on the manufacturing sector to produce more export products in order for the economy to reach growth. (Le Cadran de Cofidis, 2005). Figure 2: UK Net Lending for Consumer Credit The consumer credit markets of these two countries also differ in terms of instruments used by the consumers to utilize credit. The UK consumer credit market is the biggest market for bank-issued credit cards by international banks. British consumers rely on Visa, Mastercard and American Express to fund their transactions. (Bank Econ, 2003). In contrast, overdrafts are an important source of revolving credit in Germany but it is less important in the UK. Credit cards are not that sought after and utilized by the German consumers. The international credir card issuers have determined that Germany still poses a considerable area of growth in the expansion of the size and structure of the market for ATMs, credit cards, debit cards, store cards and smart cards. Key players in the market (the issuers and operators) can still expand number of cards in circulation, numbers transactions and value of transactions. In a sense, consumer credit has become an indispensable part of the German households for the past twelve years. It is also fair to say that there is a growing maturity among German consumers today. (Bank Econ 2003). In Germany, about 3.13 million individuals were over-indebted in 2002, according to the GP Forschungsgruppe. This estimate is based on the declaration of inability to pay, data provided by the credit registration and debt counselling agencies. The ZUMA Institute released figures for 2004: about 8.1% of all German households are heavily in debt, 11.3% in the former East Germany including Berlin and 7.2% in the former West Germany. (See Table 1: Overindebtedness in Germany). TABLE 1 : Overindebtedness in Germany (in millions of individuals) YEAR/ AREA 1997 1999 2002 East Germany 0.58 0.87 0.94 West Germany 2.1 1.9 2.19 TOTAL 2.68 2.77 3.13 In Germany, consumer credit and mortgage credit merge as the consumers arbitrage between the two forms of credit. For example, they obtain a cheaper credit on the mortgage credit market and then use it to finance the purchase of services instead of using it for housing purposes. Based on a report by the Deutsche Bundesbank, it is difficult to distinguish between consumer credit and mortgage credit from statistical sources. Consumer credit statistics in Germany, France, Italy and the United States cover all lenders. The statistics for Germany include all lenders but only provide a distinction between loans made by banks and non-banks. (Guardia, 2000). The corset, the system established to control lending in the United Kingdom, was abolished in 1980. From 1990 to 1997, the weight of consumer credit in the economy was the highest in Sweden (14.8%), the United Kingdom (10%) and Germany (11%) among EU countries. Germany’s share of consumption financed by credit amounts to a high level of about twenty percent (20%). The Germans are by far the most indebted citizens of the euro zone accounting for a growth of more than four percent (4.2 %) in 2005. In comparison to Germany’s figures, the United Kingdom’s share of consumption financed by credit amounts to only fifteen percent (15%.) The most significant trend in consumer credit markets over the last decade is the increase in the share of credit instruments associated with payment cards in the total consumer credit. In the UK, the share of credit cards stood at 15% of the total consumer credit outstanding in 1987 and rose until 21% in 1997. In Germany, the share of revolving credit has fallen slightly since 1980 and it accounted for 11% of total consumer credit in 1997. (Guardia, 2000). Consumer credit in the UK had been rising during these years. However, government reforms have been established and implemented to ensure that continued growth in the UK consumer credit sector will not penalize the consumers by way of heavy and unregulated consumer debt. The German government needs to implement measures to rein in runaway consumer spending that may lead to more serious problems for the economy later on if this is left unchecked. WORKS CITED Balaguy, H. (1996): Le crédit à la consommation en France, Que sais-je? Centre d’Information sur l’Epargne et le Crédit (1998): Bulletin du CIEC, No 211, 4è trimester. BankEcon (2003), Guide to Consumer Lending in Europe, December (retrieved from www.bankecon.com). Guardia, Nuria. Consumer Credit in the EU. European Credit Research Institute, 2000. Hewitt, Patricia. Fair. Clear, Competitive: Consumer Credit in the 21st Century. UK Parliament, 2003. Jentzsch, N. (2003). The implications of the new consumer credit directive for the EU credit market integration, Position Paper, FU Berlin-John F. Kennedy Institute Berlin, 22 April. Launoo, Karen and Almudena de la Mata Munoz. Integration of the EU Consumer Credit Market. CEPS Working Document No213. November 2004. Read More