In Gloomy prospects for UK consumer spending in 2012? we talked about how consumer spending can be affected by the financial position of households. Figures from United Kingdom National Accounts – Blue Book 2011 (see Tables 6.1.9 and 10.10) give the latest complete set of balance sheets for the UK household sector. The figures are for 2010 and in this blog we provide a brief overview of what these figures reveal.
In effect, there are two main balance sheets of interest for households (and non-profit institutions serving households (NPISHs), i.e. charities and voluntary organisations). The first details their net financial wealth and the second their physical wealth, also known as their non-financial wealth. We begin with net financial wealth. This is found by subtracting financial liabilities (debt) from financial assets. The household sector in 2010 had financial liabilities of £1.54 trillion equivalent to 1.6 times its disposable income for the year or 1.1 times the nation’s Gross Domestic Product. Of these liabilities, £1.2 trillion was mortgage debt, i.e. loans secured against property. On the other hand, the sector had financial assets of £4.3 trillion equivalent to 4.4 times its disposable income in 2010 or 3 times GDP. Of these financial assets, the value in pension funds and life assurance was £2.27 trillion.
The net financial wealth of households and NPISHs in 2010 was £2.8 trillion, 2.9 times the sector’s disposable income for the year or 1.9 times GDP. To this we need to add physical wealth of £4.9 trillion, a massive 5 times the sector’s disposable income or 3.3 times the nation’s GDP. The majority of this is residential buildings the value of which were put at £4 billion for 2010. This demonstrates the significance of housing to the UK household sector balance sheet.
If we now add physical wealth to net financial wealth, we find that in 2010 the household and NPISH sector had a net worth of £7.7 trillion. To put this in context, it is equivalent to 7.8 times the disposable income it earned in 2010 and 5.3 times the UK’s Gross Domestic Product. While these are enormous figures it is worth noting that in 2007 the sector’s net worth was £7.4 trillion, equivalent to 8.5 times annual disposable income.
A trawl through the figures clearly shows the impact of the financial crisis on the sector’s net worth. From £7.4 trillion in 2007, net worth fell in 2008 to £6.6 trillion or 7.2 times annual disposable income. However, 2009 and 2010 did see the households’ net worth increase again – including relative to its disposable income. This has been the result of its net financial wealth increasing. Net financial wealth in 2010 was 9.8 per cent higher than in 2007. However, the depressed housing market has continued to adversely impact on the sector’s net worth. Physical wealth in 2010 was 0.7 per cent lower than in 2007.
Of course, while these empirical observations are undoubtedly interesting, the key question for debate is how these patterns affect household behaviour. Of particular importance, is how changes in both the household sector’s total net worth and the components making up the total will translate into changes in consumer spending. Economists are increasingly recognising that in understanding consumer spending patterns we need to gain a deeper understanding of the impact of the balance sheets on consumer spending. It is quite likely that many retailers when forming their plans for the year ahead will be analysing the potential impact of household finances on spending behaviour. Developing strategies to respond to the state of the household balance sheets may be crucial to their success.
In the context of the household balance sheets, explain the difference between the concepts of stocks and flows.
Illustrate with examples your understanding of what is meant by secured and unsecured debt. What factors are likely to affect the growth from one period to another in the stocks of secured and unsecured debt outstanding?
Draw up a list of possible factors that could affect the value of the household sector’s net financial wealth. Now repeat the exercise for non-financial wealth.
Draw up a list of ways in which you think changes to the values of items on the household balance sheets could affect consumer spending. After drawing up this list consider their significance in 2012.
What sort of items would be included in the balance sheets of firms and of government?
A key determinant of our economy’s rate of growth over the year ahead is likely to be the behaviour of households and, in particular, the rate of growth in consumer (or household) spending. In other words, your appetite for spending will help to determine how quickly the economy grows. The importance of household spending for the economy is straightforward to understand given that it accounts for roughly two-thirds of the total demand for firms’ goods and services, i.e. two-thirds of aggregate demand. In its November 2011 Economic and Fiscal Outlook the Office for Budget Responsibility presents it forecasts for economic growth and household spending. The following table summarises these forecasts.
The OBR are forecasting that household spending will fall in real terms in 2011 by 1.1 per cent and grow by only 0.2 per cent in 2012. This is not good news for retailers nor, of course, for the economy. The drag on consumer spending growth is largely attributed to expected falls in real disposable (after-tax) incomes in both 2011 and 2012. In 2011, the household sector’s real income is forecast to decline by 2.3 per cent and then by a further 0.3 per cent in 2012.
The OBR’s figures on spending growth critically depend on the ability of households to absorb the negative shock to their real income. Empirical evidence tends to show that household spending growth is less variable than that in income and that households try and smooth, if they can, their spending. This means that the marginal propensity of households to consume out of changes to their income is below 1 in the short-run. In fact, the shorter the period of time over which we analyse income and consumption changes the smaller the consumption responses become. This is consistent with the idea that households are consumption-smoothers disliking excessively volatile spending patterns. In other words, the size of our monthly shop will usually vary less than any changes in our real income.
Of course, consumption-smoothing cannot be taken for granted. Households need the means to be able to smooth their spending given volatile and, in the current context, declining real incomes. Some economic theorists point to the importance of the financial system in enabling households to smooth their spending. In effect, households move their resources across time so that their current spending is not constrained solely by the income available to them in the current time period. This could mean in the face of falling real income perhaps borrowing against future incomes (moving forward in time expected incomes) or drawing down past savings.
The ability of households to move future incomes forward to the present has probably been impaired by the financial crisis. Banks are inevitably less cautious in their lending and therefore households are unable to borrow as much and so consume large amounts of future income today. In other words, households are credit-constrained. Furthermore, it is likely that households are somewhat uneasy about borrowing in the current climate, certainly any substantial amounts. Uncertainty tends to increase the stock of net worth a household would like to hold. A household’s net worth is the value of its stock of physical assets (largely housing wealth) and financial assets (savings) less its financial liabilities (debt). If households feel the need for a larger buffer stock of wealth to act as a sort of security blanket, they will not rush to acquire more debt (even if they could) or to draw down their savings.
The impairment of the financial system and the need for a buffer stock are two impediments to households smoothing their spending. They tend to make consumption more sensitive to income changes and so with falling incomes make it more likely that consumption will fall too. There are other related concerns too about the ability and willingness of consumers to smooth spending. Uncertainty arising from the volatility of the financial markets imposes liquidity constraints because households become less sure about the value of those savings products linked to the performance of equity markets. Consequently, they become less certain about the money (liquidity) that could be raised by cashing-in such products and so are more cautious about spending. Similarly, the falls in house prices have reduced the ability of households to extract housing equity to support spending. Indeed, with fewer transactions in the housing market the household sector is extracting less housing equity because it has been quite common, at least in the past, for households to over-borrow when moving and use the excess money borrowed to fund spending.
In short, there are many reasons to be cautious about the prospects for household spending. The expected decline in real income again in 2012 will ‘hit’ consumer spending. The question is how big this ‘hit’ will be and crucially on the extent to which households will be able to absorb it and keep spending.
What do you understand by a consumption function? What variables would you include in such a function?
Using the figures in the table in the text above, calculate ‘rough’ estimates of the income elasticity of consumption for each year. Why are these estimates only ‘rough’ approximations of the income elasticity of consumer spending?
Draw up a list of factors that are likely to affect the strength of consumer spending in 2012. Explain how similar or different these factors are likely to have been to those that may affect spending during periods of strong economic growth.
Explain what you understand by the term consumption-smoothing. Explore how households can smooth their spending and the factors that are likely to both help and prevent them from doing so.
What do you understand by the net worth of housholds? Try drawing up a list of factors that could affect the net worth of households and then analyse how they might affect consumer spending.
Twice a year, directly after the government’s Spring Budget and Autumn Statement, the Institute for Fiscal Studies gives its verdict on the performance of the economy and the government’s economic policies – past and planned. This year is no exception. After the Chancellor had delivered his Autumn Statement, the next day the IFS published its analysis. And what grim reading it makes.
• Real average (mean) incomes in 2011 will have fallen by 3%. • Between 2009/10 and 2012/13, real median household incomes will have fallen by 7.4% • Over the same period, real mean household income will have fallen by 4.7% – easily the biggest 3-year drop since records began in the mid 1950s. • Real mean household incomes will be no higher in 2015/16 than in 2002/03. • The poorest will be hardest hit by the measures announced in the Autumn Statement. • Infrastructure spending of £4bn to £5bn will only go some way offsetting the effects of £17bn capital spending cuts over the Parliament. • The economy will be 3.5% smaller in 2016 than thought in March. • The structural budget deficit is 1.6% higher than thought in March. • That will extend to 6 years the period over which total spending will have been cut year on year.
Referring to this last point, Paul Johnson, director of the IFS, said in his Opening Remarks, “One begins to run out of superlatives for describing quite how unprecedented that is. Certainly there has been no period like it in the UK in the last 60 years.” Referring to the fall in real incomes, he said, “Again we are running out of superlatives to describe just how extraordinary are some of these changes.”
Commentators have referred to the “lost decade” where the average Briton will not have seen an increase in real income.
Why is it likely that the median real income will have fallen by more than the mean real income?
Why is the structural deficit now estimated to be some 1.6 percentage points higher than was estimated by the OBR back in March 2011?
How could the structural deficit be affected by a prolonged recession? Is this a case of hysteresis?
What are the government’s fiscal rules?
Is the IFS predicting that the rules will be met? What might adversely affect this prediction?
If technological progress is allowing a continuous increase in potential real GDP, why will median real incomes have fallen over the 13 years between 2002/03 and 2015/16? What might have affected long-term aggregate supply adversely?
On Tuesday 29 November, the Chancellor of the Exchequer delivered his Autumn Statement. This presented the outlook for the UK economy, with forecasts supplied by the independent Office for Budget Responsibility (OBR). It also contained details of government fiscal measures to tackle various macroeconomic problems, including economic slowdown and high levels of national debt.
The outlook for the UK economy came as no surprise. Things are looking much bleaker than a few months ago. The OBR, along with other forecasters, has downgraded its predictions of the UK’s growth rate. Although it is still forecasting positive growth of 0.9% this year and 0.7% in 2012, these rates are well below those it predicted just eight months ago. In March it forecast growth rates of 1.7% for 2011 and 2.5% for 2012.
To make things worse, its growth forecasts are based on the assumptions that the eurozone crisis will be resolved with little or no effect on the UK. But even if that were so, the debt reduction plans in the eurozone are likely to drive the eurozone back into recession. This, in turn, will impact on UK exports, more than 50% of which go to eurozone countries.
The OBR forecasts that national debt will be 67% of GDP this year and will rise to 78% by 2014/15 but then start to fall. Government borrowing is forecast to be £127bn this year, falling to £120bn in 2012/13 and then more substantially each year after that to £24bn in 2016/17.
So what measures were included in the Autumn Statement? These are detailed in the articles below, but the key ones were:
• a programme of credit easing, which will underwrite up to £40bn in low-interest loans for small and medium-sized businesses. • £5bn of public money to be invested in infrastrucuture projects and a further £5bn in the next spending round. Agreement had been reached with two groups of pension funds to invest a further £20bn of private money in infrastructure projects. • an additional £1.2bn for capital investment in schools. • A cap on public-sector pay increases of 1% per year for the two years after the current two-year pay freeze.
The following videos and articles give details of the forecasts and the measures and give reactions from across the political spectrum.
When governments run deficits, these must be financed by borrowing. The main form of borrowing is government bonds. To persuade people (mainly private-sector institutions, such as pension funds) to buy these bonds, an interest rate must be offered. Bonds are issued for a fixed period of time and at maturity are paid back at face value to the holders. Thus new bonds are issued not just to cover current deficits but also to replace bonds that are maturing. The shorter the average term on existing government bonds, the greater the amount of bonds that will need replacing in any one year.
In normal times, bonds are seen as a totally safe asset to hold. On maturity, the government would buy back the bond from the current holder at the full face value.
In normal times, interest rates on new bonds reflect market interest rates with no added risk premium. The interest rate (or ‘coupon’) on a bond is fixed with respect to its face value for the life of the bond. In other words, a bond with a face value of £100 and an annual payment to the holder of £6 would be paying an interest rate of 6% on the face value.
As far as existing bonds are concerned, these can be sold on the secondary market and the price at which they are sold reflects current interest rates. If, for example, the current interest rate falls to 3%, then the market price of a £100 bond with a 6% coupon will rise to £200, since £6 per year on £200 is 3% – the current market rate of interest. The annual return on the current market price is known as the ‘yield’ (3% in our example). The yield will reflect current market rates of interest.
These, however, are not ‘normal’ times. Bonds issued by many countries are no longer seen as a totally safe form of investment.
Over the past few months, worries have grown about the sustainability of the debts of many eurozone countries. Bailouts have had to be granted to Greece, Ireland and Portugal; in return they have been required to adopt tough austerity measures; the European bailout fund is being increased; various European banks are having to increase their capital to shield them against possible losses from haircuts and defaults (see Saving the eurozone? Saving the world? (Part B)). But the key worry at present is what is happening to bond markets.
Bond yields for those countries deemed to be at risk of default have been rising dramatically. Italian bond yields are now over 7% – the rate generally considered to be unsustainable. And it’s not just Italy. Bond rates have been rising across the eurozone, even for the bonds of countries previously considered totally safe, such as Germany and Austria. And the effect is self reinforcing. As the interest rates on new bonds are driven up by the market, so this is taken as a sign of the countries’ weakness and hence investors require even higher rates to persuade them to buy more bonds, further undermining confidence and further driving up rates.
So what is to be done? Well, part of the problem is that the eurozone does not issue eurobonds. There is a single currency, but no single fiscal policy. There have thus been calls for the eurozone to issue eurobonds. These, it is argued would be much easier to sell on the market. What is more, the ECB could then buy up such bonds as necessary as part of a quantitative easing programme. At present the ECB does not act as lender of last resort to governments; at most it has been buying up some existing bonds of Italy, Spain, etc. in the secondary markets in an attempt to dampen interest rate rises.
The articles below examine some of the proposals.
What is clear is that politicians all over the world are trying to do things that will appease the bond market. They are increasingly feeling that their hands are tied: that they mustn’t do anything that will spook the markets.
Explain the relationship between bond yields and (a) bond prices; (b) interest rates generally.
Using the data sources above, find the current deficit and debt levels of Italy, Spain, Germany, the UK, the USA and Japan. How do eurozone debts and deficits compare with those of other developed countries?
Explain the various proposals considered in the articles for issuing eurobonds.
To what extent do the proposals involve a moral hazard and how could eurobond schemes be designed to minimise this problem?
Examine German objections to the issue of eurobonds.
Does the global power of bond markets prevent countries (including non-eurozone ones, such as the UK and USA) from using fiscal policy to avert the slide back into recession?
